Practical Law

A developer client of mine recently asked me about “guaranteed maximum price” contracts. He had heard mention of them, was keen to keep overspends on his project to a minimum and was under the impression that they would set the contract sum in stone. Thinking this sounded too good to be true, he asked me whether this could be right. 

Unfortunately, my answer was “No”. The concept of a guaranteed maximum price (GMP) is something of a myth in practice. The term “GMP” means different things to different people, and various types of arrangement are often loosely referred to as a “GMP”. There is no one size fits all definition, which can lead to confusion and waste time and money if the parties haven’t discussed the detail and discover later that they understood the term to mean different things. However, a common theme across them all is that a contract which offers a truly guaranteed maximum price is rare indeed.

With that in mind, I thought it worth taking a look at three of the contracting arrangements I have encountered in practice, which have been described by the parties as “GMP” contracts.

Lump sum contract

The idea of a lump sum contract is that, before work starts, the parties agree a “lump sum” price for the works. That price will then be adjusted only on the occurrence of certain circumstances specified in the contract. If the works cost more than the agreed price for any other reason, that cost overrun will be borne by the contractor.

Some employers think that, under a lump sum contract, the price is fixed and will never change. However, this view is clearly misconceived. For example, no contractor will agree to shoulder the risk of cost increases due to changes requested by the employer, nor where the employer without good reason has actively obstructed the progress of the works.

Most contracts, for example the JCT forms, list a number of other grounds on which the contract sum may change. Examples include employer’s instructions to open up the works (where no defect is found) or the discovery of antiquities.

If the employer wishes to keep tighter control of the contract sum, the scope for adjustment may be reduced by deleting some of these additional grounds. Where the final list is short, the resulting contract may be referred to as a “GMP” contract. However, the contract sum will always be capable of change in some events, as indicated above.

Two stage tendering

Another scenario where the term “GMP” can be used is in the context of a two stage tender process. Here, the employer sets the GMP at the first stage as the most it is prepared to pay; in effect, its budget cap for the works. The idea is that, during the second stage, the parties will work together to find cost reductions and that, in any event, the finally agreed contract sum will not exceed the GMP.

It is often thought that a GMP arrangement is only appropriate for use where the parameters of a project are certain. The thinking is that setting the GMP involves assessing the risks that may arise and transferring them to the contractor, which then carefully takes account of them when fixing its price. Clearly that will not be the case in a two stage tender scenario, since by its nature the project will not have been fully defined when the GMP is set. Here the employer’s motivation is different, namely to indicate the financial limit within which it is prepared to work and to gain confidence that the project will stay within budget.

Of course, the risks of two stage tendering are well known and the use of a GMP doesn’t in reality address those risks at all. At the end of the day, the contractor can’t be forced to enter into a contract at a price with which it is uncomfortable. That being the case, the GMP is really no more than a management tool and a guide to what the employer is looking for. If the employer thinks it offers it any greater comfort than that, it is misguided.

Target cost contract

I have also encountered a GMP arrangement in the context of a target cost contract. Here, unlike in a lump sum contract, the contractor is paid (broadly) the actual cost of carrying out the works. It then shares, in pre-defined proportions, in any savings or overruns against the agreed target price. The GMP gloss simply means that the contractor bears all cost overruns; in other words, its share of any “pain” is 100%. That is all very well; but, leaving aside the administrative burden of recording and monitoring actual costs incurred, it is likely simply to drive the contractor to look for reasons to increase the target, so that the risk of overruns is minimised. In other words, its focus is no longer on cost savings, but on claims.

Final thoughts

While these arrangements clearly differ significantly in their detailed operation, one thing is common to them all. The employer is seeking to impose more risk on the contractor, and it will always pay a premium for doing so. Indeed, in an extreme case the employer may make the project so unattractive that contractors will not want to bid for it at all. Whether this is ultimately in the employer’s interests is something that it should consider carefully before launching down the GMP route.

In summary, a GMP contract rarely does what it says on the tin. The idea that the contract price can be set in stone is a myth. Having said that, if a client wishes to stick to its budget and avoid cost overruns, there are various ways that it can do this. Transferring risk is one of them, depending on the nature of the project, contractor appetite in the market and of course the level of premium that it is willing to pay in return. Robust identification and management of key risks (ideally up front) is another. The key is that the client needs to be very clear on what its real drivers are.