How do contractors blow budgets and still get paid?

October 29, 2006 9:40 AM

Large projects that run over budget and the contractors get paid instead of eating the extra costs. Why?

We've all heard of of large, complex projects (bridges, aeroports, billing systems, etc.) running over budget. You know the ones - budgeted 10 mil, now they are 30 mil with no end in sight.

Now, i can see how this happens when a project is strictly within a company since no money is actually being passed around (it just moves from one department to another e.g. HR to IT.) But what happens when the work is being done by outside contractors and we're talking real money? Every project i've been on (admittedly, mostly webdev) - there was some sort of deliverable - and an expectation that the amount quoted would be the amount invoiced. And if the contractor didn't meet those goals, then they didn't get paid (at least not in full or not very quickly).

So, how do outside contractors manage to "blow the budget" and still get paid? What's their trick?

posted by kamelhoecker to Work & Money (20 answers total)

I think many times the initial contract probably specifies that delays or new situations or new conditions or changes of plan outside the control of the contractors may increase the final cost. And all of those things and more happen.
posted by visual mechanic at 9:49 AM on October 29, 2006

by having it written into the contract. Should a bridge builder have to eat it if the price of cement doubles after a contract is signed? If specifications change after signing who is to pay for the extra or different work.

Also say the builder/developer is a LLC (limited liability corporation). If they get into a negative profit situation, they will just go bankrupt. So if there are big cost-overruns the contract will be renegotiated so that the partial work can be completed.
posted by MonkeySaltedNuts at 9:57 AM on October 29, 2006

These contracts are most likely bid as "time and materials", with some sort of price estimate given up front.

Here is one article from Today's Engineer.

[Background: I work on "fixed price" software contracts for a private DoD contractor. In this environment, if our costs exceed our bid, we eat the difference. It sucks. We all wish we had T&M contracts.]
posted by blind.wombat at 10:08 AM on October 29, 2006

Besides it being a cost + percentage/time & materials job, there's usually a "change clause" built into the contract - new work needs to be done that wasn't included in the contract, the owner requests a design change, or the plans just contained an error. Change orders can be a very contentious area between the owner and the contractor.
posted by milkrate at 10:44 AM on October 29, 2006

If change orders are not built into a contract it would be economically unviable for most work to get done. From my understanding of contract law, without change orders the contractor would have to eat the cost unless it was incredibly unforseeable. Many clients would rather have the work done than sue for breach of contract and have to find another general contractor.
posted by geoff. at 11:01 AM on October 29, 2006

geoff. is on the right track. I am partial owner of a small business that does audio-visual installations for schools, businesses, govt., etc. We always present a detailed proposal with a set price and a scope of work that is mutually agreed upon before we start a job. Yet there are often cirumstances that cause change orders that raise the price of the project - conditions of the installation environment that weren't disclosed to us ahead of time (ceiling obstructions that prevent us from mounting the equipment in the originally agreed upon manner, electrical wasn't installed beforehand like we told the client was required, etc., etc.) or, more commonly, once we are out on the job site the customer decides that since we are out there anyway they'd also like to have A, B, and C done which wasn't part of the original proposal.
posted by The Gooch at 11:17 AM on October 29, 2006

As everyone above has said, it all depends on the contract.

In some cases the contract is written on a non-negotiable fixed price basis but that's still no guarantee of sucess:

Here in the UK, Accenture recently walked away from a 2 Billion pound fixed price IT contract when it became clear they could not make a profit. "Accenture’s strong preference now appeared to be exit the programme entirely, while avoiding making penalty payments to CfH which it is understood to be liable for under the terms of its contract."
posted by Lanark at 11:25 AM on October 29, 2006

Response by poster: exellent info! the time-and-materials vs fixed-cost was what i was looking for.

This also clears up the difference between a quote (fixed price) and an estimate (more t&m). I had been using those terms rather loosely.

re: change clauses - yes this is key. I need to work out a better system so that i'm not getting constantly bitten by the never-ending-changes bug. scope-creep is so tempting with smaller software projects (and i am often my own worst enemy).

lanark - great link. a good example of how performance penalties can backfire.

thanks again!
posted by kamelhoecker at 12:13 PM on October 29, 2006

On public projects, the costs are low-balled to get public buy-in. Then--surprise, surprise--the costs "unexpectedly" escalate. For Exhibit A, I present the Portland Aerial Tram. First, the city "forgot" to include soft costs, then the Chinese drove up the price of concrete and steel, then the Swiss let their currency rise against the dollar, and then, and then, and then ... next thing you know the cost almost tripled!
posted by GarageWine at 12:55 PM on October 29, 2006

Feature Creep is the bane of projects like this. When these kinds of project fail there's always plenty of blame to spread around, but a large part of it belongs to those who let the contract without really understanding ahead of time just what they really want.

More often than not, that is the primary cause of the failure.
posted by Steven C. Den Beste at 1:00 PM on October 29, 2006

In my experience major civil works are never done on a "cost plus" basis (ie time + materials, you get paid for your costs plus get given some profit). It's just too open to abuse.

You bid an amount but tie it very, very tightly to a fixed scope. Anything outside that scope is a variation and you negotiate a new price. I've heard it bandied about that you typically assume you'll get about 30% more than you initially bid due to variations.

Also as others have stated, the contractor won't assume the risk on materials price changes over a long time period, or even things like bad weather. If you wanted companies to assume this risk it would just be built in to the initial bid price.

The big projects I've worked on have all be based on a standard contract called AS4000. It is very largely based around fairness. For example you cannot charge penalties as punishment for missing a milestone, you can only claim reasonable expenses that that missed milestone causes you.
posted by markr at 1:15 PM on October 29, 2006

I'm with GarageWine on this one.

When it comes to public projects, I've always assumed that the government and the contractors sit around a big table, and everyone around that table knows the project is going to cost forty million dollars ... and then they walk out the door and announce it'll cost ten million, just because nobody wants to tell the taxpayers the truth.
posted by AmbroseChapel at 5:15 PM on October 29, 2006

No, Steven C, bridges and houses usually don't suffer from feature creep. My guess is you don't have a hammer but a keyboard, whereupon everything looks like a software problem.
posted by springload at 5:38 PM on October 29, 2006

Also keep in mind that it's really easy to say the contractors will eat the cost overruns. In reality, it's more likely they'll suddenly not end up with any overruns at all, due to cutting corners and using lower quality materials. The budget will be met but at what cost?
posted by smackfu at 6:44 PM on October 29, 2006

At a more practical (cynical?) level, supposing you've hired a contractor to build a bridge, and the time's up and the money's gone and they've only built half a bridge, if they say to you "Well, you can pay us some more money and we can finish the bridge, or we can walk away and leave you with half a bridge", what are you gonna do?
posted by chrismear at 11:42 PM on October 29, 2006

Typically on time and material contracts, a price increase of cement and asphalt would be eaten up by the contractor. Once a bid item is contracted at a specific price, that price cannot change, that is why it is called a "contract". Of course, if a bid item was not on the original contract and needs to be added as a change order, the contractor can charge whatever they want.

An increase in quantities beyond that of the original bid is covered by the contracted bid price wthin reasonable limits. A contractor can anticipate what bid items will most likely increase on a contract and keep that bid price higher than his costs and lower other bid items to make up the difference while still remaining the low bidder. Then he will make decent money on all the change orders on that overpriced bid item. Bidding is risky for the contractor especially when prices increase before the contract is finished. Many contractors didn't do well when gas prices increased this past year.
posted by JJ86 at 5:52 AM on October 30, 2006

Another huge factor in this that I see all the time in my line of work: In competitive bid situations, which is the normal purchasing procedure for most government entities, while price may not be the only determining factor in winning the bid, it is almost always a huge factor nonetheless. So the tendency as a bidder is to price out the job at the lowest possible cost. Even keeping things totally above board, that often entails giving the customer the cheapest, most bare bones solution vs. the "best" solution.

Once the bid has been awarded, very often the customer (with some goading by the contractor) will decide that if they are spending a huge amount of money anyway on the project, they may as well go ahead and have it done right, resulting in (far less likely to need to go out to bid) expensive change orders.
posted by The Gooch at 5:55 AM on October 30, 2006

GarageWine, the usual reason why some projects get a low initial estimate is because the project is designed by consultants who really don't give a shit and they sometimes don't complete a detailed estimate because of profitability concerns. Good consultants who are very familiar with that type of project should rarely mess up on the estimate.

Every project I have worked on and some have been multi-million dollar, there has been no collusion to hoodwink the taxpayer. Unless you live in Boston, that is an urban legend. Most engineers have a high moral standard and would never let something like stay secret. Politicians OTOH wouldn't hesitate to pull that shit, but most engineers I know would out the bastards relatively quickly.
posted by JJ86 at 6:00 AM on October 30, 2006

There's a few things that can increase the cost of a project:

1. Differing site conditions - Can be anything from unsuitable ground conditions, to old utilities to indian burial grounds. Contractors are compensated for the loss of productivity and the additional work involved in working around these things.

2. Scope creep - Additional work is added to the contract. This can make sense if the work is complementary, or if economies of scale can reduce the overall price of bidding a second contract, i.e. since you're replacing the sewer, might as well pave the street while you're at it.

3. Owner direction - If the owner wants to direct the construction activity beyond what is stated in the bid documents or orders the contractor to accelerate the work, the owner can be liable for the costs involved for lack of efficiency or additional labor required to complete the work.
posted by electroboy at 6:53 AM on October 30, 2006

Also, there are two ways to design a project:

1. Put the risk on the Contractor, which results in higher bids, but fewer change orders.

2. Put the risk on the Owner, which lowers the initial cost, but results in more change orders.
posted by electroboy at 7:03 AM on October 30, 2006