How Guaranteed Maximum Price Contracts Work

Construction projects are often governed by guaranteed maximum price contracts. See more Skyscraper Pictures.

Unless you live in the Himalayas or an Amazon hut among the people of Brazil's indigenous tribes, your life is likely a series of contracts. Buying a sweater online? You are now in a contractual relationship with the virtual retailer. Heading to the local theatre to check out (or catch some Zs at) Keira Knightley's latest period piece flick? You're now subject to the terms of a contract with the theatre owner, which are probably written in small print on the back of your ticket. Hocking everything in your apartment to pay for an engagement ring? Before you get down on one knee, you should know that marriage is a contract. So is a pre-nup.

There are a number of different types of legal agreements in the world of contracts, most of which are designed to meet the needs of a particular business or personal arrangement. A construction project, for example, is often governed by a guaranteed maximum price contract (GMP). This type of legal agreement sets a ceiling or maximum price for which a person or entity will pay for a certain project. A contractor such as a homebuilder is compensated for actual costs incurred plus a fixed fee, subject to a maximum amount. As a result, the contractor is responsible for all cost overrurns and any savings resulting from cost underruns are returned to the contractee (the home buyer) [source: Vector Construction].

Consider, for example, a GMP under which a contractor agrees to build a patio in exchange for actual costs and a $3,000 flat fee, subject to a $10,000 maximum price. Upon completion of the work, the contractor will be paid for all costs so long as the total amount, including the fee, does not exceed $10,000. If the contractor's costs amount to $8,000, it will not be paid $11,000 ($8,000 in costs + $3,000 fee), but rather the $10,000 maximum price. Conversely, if the contractor's costs amount to $5,000, it will not be paid the $10,000 maximum price, but rather $8,000.

You can probably see the benefits of this for the client, but what about the contractor? Read on to discover the benefits and drawbacks of a guaranteed maximum price contract and see how this agreement compares to other common construction contracts.