How Guaranteed Maximum Price Contracts Work

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.

The Benefits, Drawbacks and Alternatives to a GMP Contract

A guaranteed maximum price contract is an attractive option for a person seeking to hire a contractor for obvious reasons: The contractee is obligated to pay no more than the maximum contractual price and recoups any cost savings that may result from efficient project control, improvement in subcontractor or supplier pricing or ideal weather conditions, among other reasons. This arrangement, however, can result in additional costs not covered under the contract. Specifically, a contractee without construction experience may be required to hire an expert to negotiate the terms and review the contractor's costs to ensure that the final tally is accurate [sources: Glazov, JMA].

For a contractor, a GMP contract provides the benefit of transferring some of the cost risk to the contractee, so long as it doesn't exceed the maximum contractual amount. Additionally, this type of contract encourages both parties to work together so that scope of work is clear: The contractor wants to make sure that all costs are covered and the contractee seeks an affordable maximum price [sources: Glazov, JMA].

While the GMP contract is popular in the construction industry, it isn't the only type of legal arrangement used in building projects. A cost plus contract is similar to a GMP agreement in that compensation is based on costs incurred and a set fee. The only difference is that a "cost plus" contract may not include a ceiling or maximum price. A fixed-price contract (also called a stipulated price or lump-sum contract), on the other hand, sets the contractor's compensation at the outset of the project. Any cost savings are typically retained by the contractor [sources: Glazov, JMA, CSIS].

Ultimately, a contractee may prefer a lump sum contract, particularly if the project isn't big enough to justify the additional expert costs. Others choose the GMP arrangement based on the lure of capped construction costs and the possibility of even saving some money in the long run. For those who choose a GMP, but want to share the incentive of keeping costs low, some contracts provide that both parties will share in any cost savings [sources: Glazov, JMA].

For those interested in learning more about construction contracting basics or other common contractual forms, visit the links on the next page.

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Sources

Center for Strategic & International Studies. "Defense Industry Initiatives Current Issues: Cost-Plus Contracts." (Feb. 24, 2012) http://csis.org/files/media/csis/pubs/081016_diig_cost_plus.pdf
Glazov, Joshua. "Construction Contracts: The 10 Most Important Terms." Construction Law Today. Jan. 18, 2010. (Feb. 24, 2012) http://www.constructionlawtoday.com/2010/01/construction-contracts-the-10-most-important-terms-price
JMA. "Contract Types." (Feb. 24, 2012) http://www.j-m-a.com/resources/contract-types.html
Vector Construction Company, Inc. "Guaranteed Maximum Contract." (Feb. 24, 2012) http://www.vectorconstruction.com/guaranteed.html

How Guaranteed Maximum Price Contracts Work

The Benefits, Drawbacks and Alternatives to a GMP Contract

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