February 28, 2017 by Krista Johanson
Risk allocation under cost-plus contracts is not always well understood by the parties who enter into them. Contractors sometimes believe they are entitled to payment for all costs incurred to perform the work, and owners sometimes believe a contractor is obligated to deliver the project at or below the cost estimate. Neither belief is entirely accurate.
In a cost-plus contract (also known as time-and-materials or cost-reimbursable), the contractor performs the work and bills for its labour and materials, plus an agreed markup. Under this arrangement the owner takes on most – but not all – risk of cost increases.
In all such arrangements, the contractor owes a duty to the owner to carry out the work with reasonable competence and economy. This means the work must be performed in a good and workmanlike manner, and the cost of construction must be reasonable. The contractor is required to keep detailed records of its accounts. The owner is not required to pay the contractor for work performed to correct defective work. For example, if a wall is painted twice because the first painting was uneven, the owner is only responsible to pay for the cost of painting it once. This principle applies whether the owner was aware of the defect or not. The contractor seeking payment bears the burden of proof to prove that its costs were reasonable.
The contractor’s risk under a cost-plus contract increases where a cost estimate is provided. Contractors often assume that “the work cost what the work cost” and the owner is required to pay that price, even when it exceeds the estimate. However, there are two important exceptions to this principle:
The estimate may be found to be a contract price, or a contract-ceiling price. To determine this, a court will review a number of factors, including whether the contractor’s markup was a percentage of total project cost, whether the owner communicated that price was its primary concern; whether the owner relied on the estimate; whether the contractor billed on a time and materials basis and provided labour and equipment rates; and whether the contractor explained that it was not assuming the risk of the contract price exceeding the estimate.
Even where the estimate is “just an estimate” and not the contract price, the contractor owes two duties to the owner:
To exercise reasonable skill and care in preparing the estimate; and
To update the owner as costs increase.
It is true that an estimate is not a warranty or a guarantee, and the contractor is not required to be “right”. But the limitations of the estimate must be clearly explained: absent changes to the work or other unforeseen circumstances, courts have consistently held that a contractor must complete the work within a reasonable variance from its cost estimate. What is “reasonable” depends on the circumstances. This author has reviewed cases in which the contractor was held to its cost estimate, plus an increase of 5 to 20 per cent.
To limit risk, contractors should clearly state in writing that estimates are non-binding, set out what costs are and are not covered, and explain the assumptions on which the estimate is based. If a contractor does not have enough information to prepare a reasonably accurate estimate, it should decline to give one. Contractors should also ensure changes to the work are documented by change orders, to justify costs were reasonable and to explain why they exceeded the estimate. Finally, the contractor should keep the owner informed of costs incurred and changes to the forecast as often as possible.
Owners should understand that an estimate will not be a ceiling price unless incorporated into the contract, and should request details in order to understand what costs are not contained within the estimate and where costs might increase. Owners should insist on regular cost updates and should review the contractor’s accounts. Where the owner requests changes to the work, the owner should also obtain cost estimates for those changes and document them with change orders in order to forestall an argument that all cost increases were owner-caused.
This article is for information purposes only and may not be relied on for legal advice.
Krista Johanson is a lawyer at the law firm of Borden Ladner Gervais LLP who practices in the area of construction dispute resolution. Send comments to firstname.lastname@example.org.