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Contractor Incentives: The Carrot vs. the Stick

By Kevin O'Beirne, PE, FCSI, CCS, CCCA, CDT posted 10-27-2020 16:43

  

Editor's Note: CSI is pleased to publish this blog from Kevin O’Beirne, PE, FCSI, CCS, CCCA, CDT. If you have an idea or opinion you would like to share with your colleagues in the AECO industry, please contact CSI Content Strategist Peter Kray at pkray@csinet.org. He would love to help publish your thoughts.

A wry, old joke goes, “The beatings will continue until morale improves.” No one enjoys being threatened before doing anything wrong, yet construction contracts do this to contractors all the time.

Contract clauses intended to discourage certain actions or outcomes are common. Among these are liquidated damages and penalties for late completion, special (conditional) damages that apply when the contractor creates environmental messes, withholding of retainage for potential non-payment of subcontractors and suppliers, performance damages for under-performing equipment or systems, and other negative inducements.

On the other hand, positive inducements to the contractor via incentives to achieve more than the contractually indicated minimums, may also have a strong influence, because a carrot can often be more attractive than a stick. This blog post presents alternative means of encouraging contractors’ positive performance.

When should incentives be included in a construction contract? In drafting the contract, the design professional or other owner-hired consultant should never include incentives without the owner’s knowledge and express (preferably written) direction, because no consultant should independently attempt to spend the owner’s money. Incentives encourage the contractor to provide greater value to the owner for added cost. Thus, the owner must set the goals and decide how expenditures will achieve them. Consultants may, of course, make the owner aware of opportunities for incentive provisions and assist the owner in evaluating whether they should be included in the construction contract.

Many incentives address completion time or the final contract price, where the incentive will be paid when the associated outcome is achieved; however, the contract should clearly indicate when each incentive will be eligible for payment. When the contractor has earned an incentive, but prior to the owner making the associated payment, a change order is often necessary to increase the contract price by the amount of the incentive.

The most common methods of incentivizing the contractor are bonus clauses, fixed fee provisions, and target price/shared cost savings provisions, as discussed below.

 

Bonus Clauses

The simplest approach to incentivize the contractor is a basic bonus clause, typically set forth in the owner-contractor agreement. Construction contract bonuses are perhaps most common as a means of encouraging the contractor to complete the work earlier than the contract time for substantial completion. This may be accomplished as either a stipulated lump sum bonus for completing by a specified early completion date, or a stipulated amount-per-day that the work is completed early.

Bonus clauses can also be used to encourage other, greater performance, such as better-than-required performance of new equipment or systems, resulting in operating cost savings to the owner over the project’s anticipated service life. For example, where equipment with a large electric motor is furnished and is determined by factory testing in accordance with a specified reference standard to be more-efficient than required, resulting in a 20-year present worth operating cost savings to the owner of, for example, $75,000, a bonus to the contractor of one-third of the operating cost savings may encourage the contractor to propose more-efficient equipment. Contracts with such incentives must clearly indicate the method of determining the incentive amount.

The opposite of a bonus is a penalty, which punishes the contractor. Penalty clauses differ from liquidated damages, which are not intended as punitive; rather, liquidated damages are intended only to compensate the owner for damages the owner is likely to incur using a predetermined amount.

An example of a penalty clause may be where a contractor fails to complete a new casino on time, thus costing the owner significant lost profit that cannot be reasonably predicted in advance. In such a situation, the construction contract might have a clause penalizing the contractor a stipulated amount per day until the facility opens for business. In addition, the contract may also include a liquidated damages provision for late completion.

When a contract has a penalty clause, in addition to liquidated damages for late performance, often a corresponding bonus clause is necessary for the penalty to be enforceable, although they do not necessarily have to be the same amount.

Model language for a bonus clause is presented in Paragraph 4.05.C of EJCDC C-520—2018, Agreement between Owner and Contractor for Construction Contract (Stipulated Price). However, the model clause of EJCDC C-520’s optional bonus clause does not address when the bonus is to be paid or the need for a change order, as discussed above.

 

Fixed Fee

When the contractor’s compensation is cost-of-the-work plus a fee—where the fee is the contractor’s overhead and profit—the fee can be either a contractually stipulated percentage of the contractor’s actual costs or a fixed fee. A fixed fee may be either a contractually stipulated amount or a stipulated percentage of the contractor’s guaranteed maximum price (GMP).

A fixed fee incentivizes the contractor to complete the work for less than the GMP because, with a fixed fee, the contractor receives the same reward (fee) regardless of the final cost. Thus, when the contractor completes the work for less than the GMP, a fixed fee provides the contractor a proportionately greater reward than a fee that is a percentage of actual costs.

Furthermore, when the fee is a percentage of actual construction cost, the contractor has a disincentive to complete the work below the GMP, because the lower the construction cost, the lower will be the contractor’s monetary reward (fee).

Because they are already part of the contract price from the time the contract is signed by the parties, fixed fees do not require a change order prior to the owner’s payment of the incentive.

Model language for a fixed fee is included in many standard owner-contractor agreements for work compensated on a cost-plus-a-fee basis, including AIA A102—2017, Standard Form of Agreement Between Owner and Contractor where the Basis of Payment is Cost of the Work Plus a Fee with Guaranteed Maximum Price, Section 5.1.1; and EJCDC C-525—2018, Agreement between Owner and Contractor for Construction Contract (Cost-Plus-Fee), Paragraph 7.01.C.

 

Target Price/Shared Cost Savings

Some contracts with cost-plus-a-fee compensation incorporate provisions called either target price or shared cost savings. When the final contract price is less than the contract’s stipulated target price (e.g., when the contract has a GMP, the target price is usually the GMP), shared cost savings provisions will indicate the contractor is entitled to a bonus equal to a contractually stipulated percentage of the difference between the target price and the final contract price (exclusive of the bonus), when the final contract price is less than the target price. For example, where the final contract price is $1,000,000 below the target price and a shared cost savings provision allocates to the contractor one-third of the difference, the contractor’s bonus for completing under the target price would be $333,333.

On some projects, target price provisions also allocate risk where the cost exceeds the target price (i.e., an overrun). Such clauses are rare and are probably most common on very large projects with significant potential for unknowns, such as differing subsurface conditions. Often, such provisions assign to the contractor all the risk of overruns when the final contract price is up to 10 to 25 percent or so above the target price. Where the final contract price is greater than this, and the contract addresses sharing the risk of significant overruns, the owner will typically be responsible for a proportion of the overrun. This reduces the potential for significant financial distress on the contractor, thus reducing the potential of contractor bankruptcy. Proper controls and monitoring must be in place to verify cost overruns and the contractor’s exercise of due diligence at controlling overruns.

An alternative approach for overrun-sharing above a contractually stipulated threshold (such as the +10 to +25 percent threshold mentioned above), provides for the owner to be responsible for all the eligible overrun cost above the stipulated threshold, although the contractor is often not entitled to any fee on the owner-paid overrun.

This writer has most often observed overrun-sharing clauses in multi-billion-dollar contracts, although the same logic may incentivize contractors on much smaller projects and also reduces the risk of disputes.

Shared cost savings provisions are often graduated, to allow the contractor a larger bonus when the contract price underrun is greater. When overrun sharing is included, such provisions may allocate to the owner a greater proportion of very large overruns. For a hypothetical project with a target price of $10 million, graduated shared cost savings with graduated overrun-sharing might be:

Difference from Target Price

Contractor’s Proportion

-$5,000,000 to -$500,000

33 percent

-$499,999 to -$200,000

20 percent

-$199,999 to target price

10 percent

Target price+$0.01 to +$2,500,000

100 percent

+$2,500,001 to +5,000,000

50 percent

+5,000,001 and greater

25 percent

Applicable percentage applies to entire difference from target price; percentages are not applied separately or incrementally.

The above example is presented solely for illustrative purposes and does not suggest typical or appropriate values.

A drawback of the graduated approach presented in the above example is that an unscrupulous contractor could potentially manipulate the documented costs to obtain the next, more-attractive level of incentive. An alternative to this is shared cost savings established by a stipulated, mathematical formula rather than a graduated table.

When the owner desires to encourage contractor substitution requests that would reduce the contract price, regardless of whether compensation is on a stipulated price or cost-plus-a-fee basis, a shared cost savings clause may stimulate such proposals. Such provisions are admittedly rare and, by encouraging substitution requests, may impose a significant burden and risk on the design professional during construction. Substitution requests spurred by a shared cost savings clause may impose pressure on the design professional to approve substitutes that provide lower quality, fewer features, or decreased performance. Furthermore, when approved, substitutes also have potential to delay the project when redesign is necessary to accommodate an approved substitute.

Shared cost savings and overrun sharing typically require a change order before the associated incentive can be paid. No standard construction contracts in widespread use in the United States currently include model language for shared cost savings or overrun sharing.

Conclusion

Sometimes, the carrot is stronger than the stick for incentivizing desired construction outcomes. When so directed by the owner, contractual bonuses, fixed fees (for work compensated on a cost-plus-a-fee basis), and target price/shared cost savings clauses can be powerful inducements to contractors.

Copyright 2020 by Kevin O’Beirne

The content of this blog post is by the author alone and should not be attributed to any other individual or entity.

Kevin O’Beirne, PE, FCSI, CCS, CCCA is a professional engineer licensed in NY and PA with over 30 years of experience designing and constructing water and wastewater infrastructure for public and private clients.  He is the engineering specifications manager for a global engineering and architecture design firm.  He is a member of various CSI national committees and is the certification chair of CSI’s Buffalo-Western New York Chapter.  He is an ACEC voting delegate in the Engineers Joint Contract Documents Committee (EJCDC) and lives and works in the Buffalo NY area.  Kevin O’Beirne’s LinkedIn page.
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Kevin:

In AIA A503-2017/2019, Guide for Supplementary Conditions (under amendments to Owner-Contractor Agreements), suggested wording is included only for liquidated damages and for bonus provisions. The commentary notes:

  •  "Unless otherwise expressly stated in the Contract, liquidated damages will be the Owner's sole remedy for the Contractor's delay in achieving Substantial Completion and the Owner would be precluded from recovering other types of damages, including direct, consequential, and special damages resulting from delay…..Care must be taken to avoid even the appearance that a liquidated damages provision will be used to extract a penalty-an amount that is not a reasonable measure of the anticipated actual damages. If it is found that the liquidated amount is disproportionate to the anticipated harm, or if there is no anticipated harm, then the amount may be judged to be an unenforceable penalty. Penalties in contracts are not generally enforceable for public policy reasons-the few exceptions are typically made by statutes granting authority to public entities, cities and municipalities."
  • "Below is an example of a bonus provision that may be used to counterbalance a liquidated damages provision such as those shown in Section 4.5. To overcome the public policy objection against penalties in contracts, some parties believe that a bonus counterpoint will cause a court to look more favorably on a liquidated damages provision."

 I knew that liquidated damages were not the same as penalties, because LD are tied to specific quantifiable monetary losses the owner may suffer. I had understood (apparently mistakenly) that a penalty clause could be used only if a bonus clause also was included.  It appears that the AIA's position is that penalty clauses are not enforceable, and so they do not include suggested wording for such clauses.

Dave Metzger FAIA FCSI