The expansion and development of organizations year after year make construction inevitable. Values recorded by the Census Bureau indicate that construction is booming. In 2015 alone, cumulative U.S. construction project spends reached $1 trillion, the highest recorded amount since 2008. Although many organizations nationwide continue to break ground on new construction, undertaking these large projects comes with a fair amount of risk. Failing to adequately understand where your organization may be at risk can lead to overspending and, in certain cases, legal disputes. Knowing the five major risk areas in construction contracts can help you manage your ongoing or upcoming construction projects to ensure you are not overpaying.
The biggest risk to an owner lies in the contract itself. Too often construction contracts are muddied with unclear language that makes it difficult to determine reimbursable project costs. When a contract is drafted using clear and transparent language, it allows every party to know exactly what the scope of work entails, which costs fall within that scope of work and which costs do not. Clauses and provisions should be written so that someone unfamiliar with the project, such as an arbitrator or judge, can easily understand the costs to be reimbursed by the owner to the contractor on the project. Clear, concise contract language can also mitigate an owner’s risk related to potential project cost issues.
For cost reimbursable guaranteed maximum price (GMP) contracts, contractors are compensated for actual costs incurred, in addition to a fee, up to a guaranteed maximum amount. Because the contractor will be compensated for actual cost as defined by the contract agreement, detailed project budgets are essential to ensure that the GMP budget is not artificially inflated. On cost reimbursable contracts, owners need to carefully review budget line items to confirm that budget amounts represent a contractor’s actual cost and comply with the provisions of the respective contract agreement. By removing unnecessary or overstated budget line items, owners can save a significant amount of money on their construction projects before construction even begins.
Each executed contract should detail the reimbursable labor rate costs associated with your contractor and subcontractors. It is important to review each of these labor rates prior to starting any work to determine whether they are in accordance with the contract agreement and represent a contractor or subcontractor’s actual cost to perform the work. Contractors selected through a competitive bidding process will likely present low, lump sum contract amounts in order to win the work. However, when contractors determine the price for change order work, it is not based on a competitive bid process. Pricing is often inflated as a result of overstated labor rates. Many organizations have benefited from contractor and subcontractor labor rate reviews in order to guarantee they are receiving the best possible price. You can drive down labor costs on your projects by using a third party construction auditor that has a database of national contractor labor rates and a comprehensive understanding of construction labor costs.
With any major construction project comes surprises that can increase the scope of work. Even if your organization drafted the project contract using clear language and selected a fairly priced contractor to do the job, there is still the possibility that additional work outside of the original estimate will be required. If you are required to deviate from your original plan, a change order will be needed. For example, if a renovation project required additional electrical work outside of the original scope, the owner and contractor would execute a change order detailing who would perform the additional work as well as the cost of materials, equipment and labor for the new scope. It is important to carefully review every change order to gain an understanding of why the change is necessary and assess pricing to confirm that it is fair to both the contractor and the project owner.
Insurance and Bond Costs
Many contractors’ project costs are often overstated as a result of contractors using complex self-insured insurance and bonding programs. Contractors can also inflate their insurance costs by billing for additional coverages not required by the contract agreement or by billing for limits in excess of the coverage required in the respective contract agreement. It is important that every owner carefully review the insurance coverage and costs related to their project to guarantee adequate insurance coverage, while also mitigating financial risk to potential insurance over-billings.
Understanding the major risk areas you face prior to beginning a construction project will help you to manage that risk from project inception to completion. At a minimum, owners need to execute clear contracts that consider the pricing of project budgets, labor rates, changes in the work, and insurance costs so that your project can stay within budget. When each of these risk areas is taken into consideration, organizations avoid costly over-billings and potential disputes.
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