The Best Laid Plans: Contingency in a Construction Contract

This article is the first of a three-part series on contingencies in construction contracts. This series will explain:

• what a construction contingency is;
• the two primary schools of thought regarding how a construction contingency fund should be used and managed; and
• construction contract drafting considerations for contingency clauses.

Armed with this information, owners and contractors will be better equipped to tackle the inevitable project surprises.

Life is full of surprises, some good and some not too good. Surprises during construction are seldom welcome events. However, experienced owners and contractors know to expect the unexpected and plan accordingly by including contingency funds in their budgets. For them, the question is not whether or not to include a contingency, but how much to set aside and how to structure and manage the fund.

What Is a Contingency Fund?

While unforeseen circumstances on a project are almost a given, even the best estimators can’t predict the cost impacts of these events. This is where the contingency fund comes in. A contingency fund is an amount of money set aside in a budget to address unforeseen circumstances. The challenge is to set the contingency with enough funds to cover unforeseen events without tying up money that could otherwise be used for the project.

There are two types of contingencies: an owner contingency fund and a contractor contingency fund. Owner contingency funds are outside of the construction contract and are most frequently used to pay for changes to the scope of work during construction (though there are limited constraints on the owner’s use of this fund). A more appropriate title for owner contingency is an “owner reserve.” Since there is little debate as to who controls this fund and how it can be used, the owner contingency fund is not the subject of this series. Instead, the focus will be on contractor contingency funds.

Unless an owner explicitly prohibits it, contractor contingency funds are generally present in every construction contract. In a lump sum contract, the contingency fund likely will not be shown in the schedule of values (SOV) presented to the owner. Instead, each line item shown likely includes some amount of contingency to cover unexpected costs. Conversely, contracts paid on the basis of actual cost plus a fee, subject to a guaranteed maximum price (GMP contracts) require the contractor to show the contingency fund as its own line item in the SOV.

When included in a lump sum contract, the contractor is generally free to use the contingency fund as it pleases (including for contractor mistakes), with no owner oversight or reporting requirements. This is generally not the case in GMP contracts. While allowable uses of the contingency fund will vary from contract to contract, generally speaking, the contingency fund is available to pay for costs resulting from unforeseen conditions which are not the appropriate subject of a change order. Examples of these costs include overtime work, adverse weather conditions, material price escalation, scope gaps, labor disturbances, subcontractor defaults and estimating inaccuracies.

The best contractor contingencies are funded at a level that balances the desire to have liquidity with the need to control risk. In GMP contracts on private projects, the contingency fund is typically between 2% to 5% of the GMP. The contract typically allows this contingency amount to grow if savings are realized elsewhere in the SOV, which most often occurs during subcontractor buyout. If any contingency funds remain at the end of the project, owners may choose to share the leftover funds, which some argue incentivizes the contractor to efficiently manage the contingency fund.

While parties are generally free to agree upon the terms for a contractor contingency fund as they see fit for a project, there are some exceptions on public works projects. For example, San Jose, California limits the contingency for public works projects to 10% to 15% of the total contract amount, depending on the type of project.1 States like Massachusetts, Maryland and Nebraska also have laws which regulate the use of construction contingencies on public works projects.2

Contractor contingency funds are a project essential; they help mitigate risks and costs in construction projects by allowing projects to continue more efficiently when unexpected circumstances arise. However, contingency funds can also be the source of significant dispute between owners and contractors. The next article will cover the sources of these disputes and the different schools of thought regarding how contractor contingency funds should be managed and used.