Any construction job is laced with myriad risks and possibilities of resultant losses. These losses may arise from delay in procuring materials, structural changes, faulty execution of ideas and rectifying the errors. All of these waste precious time and cost more money than initially estimated. Hence, most of the customers want a way to mitigate these losses. In this mindset lies the advent of Guaranteed Maximum Price or GMP Pricing Contract.
What is Guaranteed Maximum Price (GMP)?
The term GMP Pricing is prevalent in construction contracts. More often than not, it is observed in the construction business that the costs exceed the estimated or budgeted limits due to several reasons and most of them can be traced back to some errors on the Construction Business i.e. the Contractor’s side. But unfortunately, the client who has commissioned this construction work has to bear the brunt.
Hence, the arrival of GMP! Under Guaranteed Maximum Pricing (GMP) contracts, the client has to compensate the contractor for all his costs + a fee/remuneration above the costs but this entire compensation is limited to a predetermined extent.
Thus, a total sum; covering actual construction costs and fixed fees over and above that; is fixed in advance; even before the construction contract is awarded and the work begins. The maximum that a contractor can earn out of this particular contract is limited to this GMP i.e. Guaranteed Maximum Price.
What if costs are different than planned under GMP?
IN GMP, the risk of losses arising out of cost overruns is transferred to the contractor. In the instance of cost overrun, the client is not bound to compensate the contractor beyond GMP. The contractor has to bear the loss.
In case of costs being less than stipulated i.e. the work getting finished at lower costs than estimated, the client definitely enjoys a saving and is entitled to keep it solely with him.
However, depending upon the contractual agreements, he may share it with the contractor at a certain percentage of these savings.
How does it work?
For example, you are hired by a local nursery to construct a greenhouse at a GMP contract. The terms of the contract with regards to price would look something like this: The price will be reimbursement of all the costs plus a fixed fee of $ 5,000 above the costs with the Guaranteed Maximum Price of $15,000.
Here, the maximum you can earn out of this contract is $15,000. So in order to earn your full fees of $5,000; you, as a contractor, would have to limit your expenses to $10,000 or you risk losing your remuneration to that extent and pay out of your pocket.
If your total expenses for the job are $8,000, then your total earnings would be $13,000 ($8,000+$5,000). $2,000 would the saving of your client. You may get a certain percentage of this based on the terms of the agreement.
Uses of Guaranteed Maximum Price
GMP is preferred by clients whose construction projects are of such types where expenses can be estimated in advance with fair degree of accuracy. Their risk and uncertainty-bearing capacity are also limited. Hence, in order to protect themselves from this eventuality, they prefer to award contracts on GMP basis.
How is GMP different from other traditional pricing methods of Construction Contracts?
There are other traditional methods of estimating the cost price on a construction contract like Fixed Price, Cost Plus method.
GMP vs. Cost Plus
Under cost-plus contract, the final price is determined as a sum total of all the expenses deemed to be incurred over the span of construction work and a fixed margin of profit or remuneration above that. There is, in fact, no maximum limit to the number of expenses.
Cost plus contract is used where the accurate construction costs cannot be estimated in advance. Often, these are quite elaborate and complex construction projects spanning over many years and they aim to build colossal structures.
Hence, all the expenses – estimated as well as unexpected – have to be reimbursed to the contractor in addition to the profit margin. Thus, the client has to bear the risk of sudden financial losses in the event of any hitch in the construction project.
GMP vs. Fixed Price
A Fixed Price method is where both the parties – the contractor and the client – have agreed on a fixed price for the construction job on hand irrespective of the actual expenses involved. So an option of covering all the actual expenses within a particular range is available in GMP, the contractor gets only one fixed sum under Fixed Price method.
Revision of Guaranteed Maximum Price
In case of the change in customer mandate with regards to the construction work; for example revision in designs or changes in specification and quality of materials; the GMP contract contains the clause for upward revision of GMP price in order to fully compensate the contractor under changed conditions.
Quite often, a GMP contract also includes a clause for reimbursing the contractor for losses incurred due to natural disasters or events that were beyond his control like fire, shut down in one of his suppliers’ factories etc.
Advantages of Guaranteed Maximum Price
For the construction business:
- With more and more customers finding GMP an attractive option, the contractors opting for GMP will definitely have more ease in procuring contracts.
- The contractors can get funds for their working capital as well as long-term capital requirements easily from the banks as their construction schedules are accurately etched out and much detailed. This gives security to the banks in terms of their revenue generation capacity.
- The contractors also have an incentive to complete the work before schedule and keep the expenses within the budgeted estimates so as to avoid the possibility of getting penalized and earn some percentage share of savings, if the contract allows. Thus, it becomes a win-win proposition for both the parties.
For the client:
- It gives security to the client that he won’t be penalized for the contractor’s mistakes and carelessness in carrying out the project.
- As there are little uncertainties regarding the costs and an almost accurate, crystal clear estimate of the costs – there are no unpleasant surprises.
- As the project details are worked out very well in advance, the flow of work is quite smooth.
Disadvantages to the contractor :
- There may be losses to the contractor if he doesn’t have a mechanism for estimating costs accurately. He may miscalculate the costs and may have to bear losses in the event of cost overruns.
- Due to the possibility of losses, the contractor may quote the higher price for the job and may lose the contract in competitive bidding. Thus, it’s on the contractor to work out a balanced GMP.
EMP (Estimated Maximum Price) Contacts: A Better Alternative
Slowly, a relatively newer concept known as Estimated Maximum Price (EMP) is gaining acceptance wherein instead of shifting the entire risk of cost overruns to the contractor, a fair way to share such risks between both the client and the contractor is worked out and both the parties contribute to such losses.