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April 28, 2011

What’s in your construction contract?

  • Confusing simple terms could create unintended complications.
    Pillar Law PLLC


    Construction contracts range dramatically in terms of size and specificity.

    I have reviewed construction agreements that are 50 pages in length and dive into every detail imaginable, including parking regulations, dress code and what workers cannot say while on site. At the other extreme, I have reviewed contracts that basically answer three questions: what, where and how much. And in between there are an infinite variety of construction contracts, negotiated each day in Washington, covering a wide range of projects.

    Oddly, there seems to be an incredible amount of confusion surrounding certain basic contractual terms, one of which is discussed below.

    Fixed-price contracts

    A simple way to understand a construction contract is that one party is promising to pay another to undertake a certain scope of work.

    So you might expect that payment terms would be clear. And often they are, especially when it comes to fixed-price contracts, which either reward or punish the party fixing the set price for a certain scope of work.

    Fixed-price contracts are frequently paid on a draw schedule. The contractor typically invoices the customer when, for example, the project is 25 percent complete for 25 percent of the fixed price.

    The “cost” problem

    The other kind of contract that is common to construction agreements, in contrast, is often not quite so clear. There are two names for this other type of payment structure: “time and materials” or “cost plus.”

    It seems that contractors who use one term or the other usually intend to convey the same basic idea. In their eyes, the terms are entirely interchangeable. Unfortunately, there is an important difference between the two.

    Cost plus is exactly what it claims to be, the contractor’s actual cost plus markup. When it comes to calculating the cost to the customer for items such as materials purchased, it is quite simple. If the agreed markup is 20 percent, then the contractor simply multiplies its invoices by 120 percent and presents the bill to the customer.

    What happens, though, when it comes to employees’ labor under a cost-plus contract? Technically, the contract requires that the customer pay actual costs plus 20 percent.

    When it comes to employees’ labor, the question becomes: Exactly what is the contractor’s actual cost? Is it simply the hourly wage the contractor pays? Is it the hourly wage plus workers’ compensation? Are insurance and health benefits added in as a “cost?”

    Unless a contractor enjoys spending countless hours with a spreadsheet calculating its actual cost per employee, it is wise to avoid calling your construction contract “cost plus.”

    Further, if litigation arises, the contractor runs the risk of drawing a Consumer Protection Act claim, particularly in the residential remodel context. The homeowner’s attorney will no doubt allege that the contractor has engaged in deceptive billing practices — unless the contractor can precisely substantiate the exact amount of overhead allocated to each employee’s hours worked. Even an innocent mistake could lead to a great deal of drama and heartache.

    Time and materials

    A simple way to avoid this “cost” problem is to call your payment structure “time and materials.”

    When it comes to materials purchased, equipment rentals, etc., your contract will be identical to a cost-plus contract. You and the customer will have agreed to a fixed markup. You will simply present all invoices, multiplied by the agreed percentage, prior to submitting an invoice to the customer.

    When it comes to employee labor, though, it should be far simpler for both parties as time and materials.

    Rather than stating that the customer is paying actual costs, you should state the precise rate charged for each type of employee. For example, you should state in the contract that you will charge $55 per hour for your foreman, $37 for carpenters, $25 for laborers, etc.

    The reason it is so important to state the precise rate is that you have skirted the “cost” problem. No longer is it a mystery about exactly what you will be charging, as your cost, for each worker. Instead, it is clearly stated in the contract and there will be no need to go back and figure out what the per-hour workers’ compensation cost is for a given employee, insurance costs per hour, etc. Instead, you simply submit the employees’ time cards, and multiply the total by the agreed hourly rate for a given employee.

    Marking up a markup

    A related question often arises: If I use a time-and-materials contract, does that mean I cannot mark up my employees’ hours?

    The answer is that there is no set rule.

    My preference is simply to include enough of a markup in the stated hourly rate to include a profit margin in addition to covering actual costs and burden. Therefore, if you are charging $55 for your foreman, and his actual wage is $35 per hour, you have built in a $20 gross margin.

    After actual costs (insurance, benefits, etc.) you should arrive at a profit of roughly the same percentage you have agreed to charge for supplies, subs, etc. That does not mean that you cannot also mark up the set hourly rate, though. If you are clear in the contract, you could certainly state that your foreman’s rate is $55 per hour, and that you will also mark that rate up.

    I have found that it is far simpler — and cleaner — to simply state an hourly rate and not mark it up again. This also has the added benefit of making the contract appear to be more transparent. You will not risk looking as though you are trying to gouge the customer.

    During any project, a customer and an employee may strike up a relationship. The employee may innocently divulge that they are paid, say, $20 per hour. If the customer then learns you are charging $55 an hour and also marking that up, you risk the appearance that you are milking your employees’ labor. Time cards are much more likely to be scrutinized by the customer as a result.

    That is why the best course, when drafting a non-fixed price construction contract, is to be perfectly clear when it comes to employees’ hourly rates. It is as simple as stating in your contract that you will bill the customer on a time-and-materials basis, and that the following rates will apply: 20 percent markup on materials, equipment, subcontractors, and all other necessary costs; and $55 as an hourly labor rate for employees, including supervision. That way there will be no disputes relating to labor costs.

    So the next time you draft a contract, take a second or two and think about what you are actually presenting to the customer. In the long run, your time will be well spent using a clearly drafted construction contract.

    A small amount of planning can go a long way when it comes to construction contracts — unless you enjoy drama and spending countless hours with a spreadsheet, calculating exact costs. Unfortunately many contractors learn the difference only when a dispute arises. By that time it is too late.

    Seth Millstein graduated from the University of Oregon School of Law in 2002; and from the University of Washington with a master of law degree in taxation in 2003. He recently created Pillar Law PLLC, a firm representing contractors, suppliers and design professionals. Pillar specializes in liens, bond claims and contracts.

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