Risk vs. Reward

One of the many questions we get from our clients is   “Which type of Contract Methodology should I use for my facility project?” My response is always the same; “How much risk do you want to take in order to receive more reward?” When dealing with contract types, it always comes down to Risk & Reward. The one who accepts the risk should get the reward. So, no matter which method of contract you choose, how to allocate risk and reward is the measuring stick. Here are the three basic types of contracts used to deliver capital projects:

LUMP SUM:  With this method, the Risk/Reward is the Contractor’s. The following are true about this method:

  • Costs are fixed at time of bidding.
  • Schedule is fixed at time of bidding.
  • High probability for Change Orders if the scope is not well defined.

COST PLUS A FEE: With this method, the Risk/Reward is the Owner’s. The following are true about this method:

  • Costs are based on the project scope and passed directly through to the owner.
  • All bidding, negotiations, and construction costs are “open book”.
  • The fee or mark-up (lump sum or percent of cost) is negotiated at the start of the project.

GUARANTEED MAXIMUM PRICE (GMP): With this method, the Risk/Reward is Shared. The following are true about this method:

  • Maximum cost is guaranteed at the start of the project, based on an approved scope of work.
  • All bidding, negotiations, and construction costs are “open book”.
  • At the completion of the project, savings to the GMP are shared per a formula agreed to at the start of the project.

There can be one other factor that may influence the contract method you choose; you banker. The underwriter of the loan may require firm bids prior to closing on the loan. Financial institutions are not keen on accepting a lot of risk after the contract is executed.

As with many questions, there is no “One Size Fits All” answer; different contract methods work for different projects.  Give me a call and we can talk more about the truths of each method and see which method would best fit your next capital project.

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