Cost-Reimbursable Contracts – Where’s the Risk?
Whether you are a contractor or an owner, choosing the right form of contract can be critical to the success of your project. However, in order to manage/maintain the levels of risk accepted through contract negotiation, the parties must align their conduct with the form of the contract. On cost-reimbursable forms of agreement in particular, it is important for both owner and contractor to recognize how certain conduct during the project increases or decreases the potential for disputes and/or the ability to defend its assertions of claims related to time or money.
The Risk Spectrum
For the sake of discussion, consider a contractor/owner risk spectrum related to different forms of contract, with a traditional lump sum contract at one end and a pure cost-reimbursable contract at the other. Generally, the perception is that the lump-sum (or fixed-fee) agreement carries the most risk for a contractor, while the pure cost-reimbursable agreement assigns the most risk to the owner. Along this supposed risk spectrum existing between the lump sum and reimbursable contract forms, sit a myriad of variations and hybrid forms of agreement. Each form of agreement along the risk spectrum incorporates differing compensation structures and/or other provisions aimed at better balancing the risk between the contractor and owner. For example, a guaranteed maximum price (GMP) contract may fall towards the middle of the spectrum, as it is based on a reimbursable structure but includes a limit on the reimbursable costs, thereby increasing the contractor’s risk and lessening the owner’s.
Contractors and owners typically pay close attention to identifying and limiting risks when determining the best form of agreement and negotiating the particular terms of that agreement. However, once the structure of the agreement is determined, the parties to the contract can overlook how their individual actions during the project may affect their respective risk exposure – or said differently: how their actions may affect the possibility that a negotiated contract will continue to slide along the risk spectrum after contract execution. As contractors and owners get involved in contracts that incorporate elements of a reimbursable cost structure, some may not recognize the unique ways that their actions under these forms of agreement can contribute to increased risk and/or the potential for disputes. Two examples follow, one from the contractor’s perspective, and the other from the owner’s.
Risk from the Contractor’s Perspective: The Cost-Reimbursable Mindset
The first example considers additional risk that can arise under reimbursable forms of agreement when a contractor fails to contemporaneously identify and document scope changes. This conduct by the contractor can be referred to as the “cost reimbursable mindset.” Essentially what occurs when a contractor approaches a project with a cost reimbursable mindset is that the contractor focuses on the reimbursable structure of its contract and generally expects that it will be reimbursed its costs (according to the terms of its agreement) regardless of how the originally requested scope of work may change. With this mindset, the contractor does not put into place procedures for identifying and tracking changes to the base scope of work.
Under a pure cost reimbursable structure, there may not be a need to identify scope changes, or it may be problematic to do so depending on how well the original scope of work was defined. However, under different forms of agreement along the risk spectrum, a contract that has what seems to be a reimbursable structure may also include compensation formulas, fee arrangements or other requirements that make the identification and segregation of extra work more important (i.e. provisions for a target price, profit/loss sharing, incentive fees, etc.). Under these types of contracts, a contractor’s failure to consider, identify and track scope changes can have unexpected repercussions on the contractor’s ability to receive reimbursement for its costs and maximize its revenue and profit.
Under the various forms of contracts that include elements of cost reimbursement for the contractor, a contractor’s failure to identify and track scope changes can result in perceived overruns that in reality are costs that relate to extra work. These perceived overruns, in turn, can affect compensation formulas and reduce the revenue generated by the project. The failure to identify and segregate extra work can also affect the contractor’s reporting of productivity – where more hours (which are truly extra work hours) appear to be spent progressing base scope work and reports therefore indicate that the contractor is experiencing poor productivity. Depending on the particulars of a given situation, perceived overruns and/or contractor-reported productivity problems can lead to owner allegations of poor performance and/or even an owner withholding payment.
Risk from the Owner’s Perspective: Consistency of an Owner’s Course of Conduct
The second example of additional risk that can arise as a result of conduct during the project pertains to the owner’s contemporaneous review of the contractor’s detailed cost records. Reimbursable contracts typically provide that the contractor will submit detailed records in support of its costs and allow the owner the opportunity to review such records before remitting payment to the contractor. One clear way an owner can increase its risk is by failing to conduct regular and thorough reviews of the requested costs prior to payment. But even in cases when the owner performs regular reviews, these reviews and related records can affect the owner’s ability to backcharge the contractor for additional costs incurred or otherwise assert that the amount to be paid to the contractor should be reduced.
In these cases, the issue generally relates to consistency of the owner’s position. By way of example, if the owner conducts detailed reviews, approves and pays all of the contractor’s engineering costs during the course of a project, it may face difficulties arguing after-the-fact that the contractor’s engineering performance was deficient. As a result, the owner may have challenges in asserting backcharges or substantiating any alleged basis for non-payment to the contractor. Matters can become more difficult for the owner if the owner failed to provide notice to the contractor that it believed the work to be deficient, particularly if the owner was well-informed over the course of the project (i.e. received detailed reports and updates or was a very involved owner).
It is essential that contractor and owner align their conduct with the form of the contract in order to preserve the respective levels of risk anticipated in the contract. Under forms of cost-reimbursable agreements, the potential risks associated with a party’s conduct during the project may be less obvious or straightforward. Whether it is the contractor seeking reimbursement or the owner verifying those costs, both parties should consider how their actions affect their exposure to risk and act accordingly. In some cases, this may mean mid-project adjustments to routines, internal procedures and/or record-keeping practices.
About the Author
Laura Arrigo is a Project Executive at The Rhodes Group.
Articles published in The Expert Report are the opinions of the authors and do not necessarily represent or reflect the policies or opinions of The Rhodes Group. The Expert Report may not be reproduced in whole or in part without the permission of the publisher.