Construction Projects: Issues with Cost Estimates

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White & Case LLPThe cost of construction materials has risen like never before. This, in turn, creates pressure for parties to use cost estimates and budgets rather than "fixed price" contracts. Providing cost estimates can therefore be hazardous. Two recent cases highlight some of the issues that can arise when estimates are used. 

Damages for Underestimating the Cost of Construction Works

In Morris v Leaney [2022] NSWCA 95, the New South Wales Court of Appeal considered the extent of damages that might be recoverable as a result of a negligent cost estimate.

  • An architect was engaged to design extensive home renovations. The employers indicated to the architect that their budget was around $600,000.
  • The architect prepared a design, a builder was engaged, and the works ended up costing around $780,000.
  • The employers alleged that the architect had negligently failed to advise them as to whether their objectives could be achieved within their budget. They claimed damages from the architect in the amount of $450,000, being the difference between: (a) the cost of the building works; and (b) the increase in the value of the land resulting from those works (the increase in value being $330,000).

The court concluded that, in principle, damages could be recovered on such a basis. However, such an approach seems problematic, for at least two reasons.

First, it suggests that the architect warranted that the value of the property would be increased by (at least) the cost of the works, at least by accepting liability for any shortfall in the event his or her estimate was negligent. Although such an outcome is desirable from an employer’s perspective, consultants such as architects rarely, if ever, give such a "value add" warranty.

Secondly, there is the question of whether an employer suffers a loss at all in such a case. If an employer pays $780,000 for $780,000 worth of building work, the employer has arguably "got what it paid for", even if the employer entered upon the project on the basis of a negligent underestimate of costs provided by a consultant.

A more likely situation where an actual loss is suffered due to a cost underestimate is where a contractor enters into a "fixed price" contract on the basis of a negligent estimate prepared by a consultant. If the contractor faces increased costs which are irrecoverable from the employer, those costs may usually be claimed as damages from the negligent consultant; however, any recovery of damages may be curtailed by limitations or exclusions of liability in the consultant’s contract of appointment.

Does "Estimate" Mean "Fixed Price"?

The Sky’s The Limit Transformations v Mirza [2022] EWHC 29 (TCC) demonstrates a different kind of "estimate risk" – that an estimate might be binding. 

  • An employer instructed a contractor to undertake renovation works to his home. 
  • Following a disagreement over an interim payment, the contractor terminated the agreement with the employer, and sought to recover the amounts that the employer had refused to pay.
  • As part of that dispute, a question arose as to whether the agreement was a fixed price contract, or a contract for a reasonable price, based on an estimate. During the negotiation of the contract, the contractor had provided a number of "estimates" to the employer, the last of which formed the basis of their contract.

The court decided that, despite the use of the term "estimate" in the documents and exchanges between the parties, the agreement was in fact a fixed price contract. The term "estimate" had been used inconsistently, including in relation to calculations made following a site visit, and with the benefit of detailed quotes from suppliers. 

The matter was put beyond doubt by the parties’ use of a modified Federation of Master Builders standard form, which was plainly intended to be used as a fixed price contract. As a result, the contractor’s "estimate" was to be understood as a commitment to complete the works for a fixed price.

The court’s decision highlights that whether an "estimate" constitutes (i) an indication of expected costs or (ii) a quotation to which a contractor is committing will depend on the circumstances of the negotiations and the terms of the agreement. 

Further Considerations

At a time when inflationary pressure makes it difficult to provide accurate estimates, reaching agreement as to which party should bear the risk of cost overruns is challenging. If employers seek commitment to a fixed cost, they are likely to face either pessimistic estimates during the tender process, or a steady stream of claims during the construction phase. If contractors want to adopt a variable costs model, employers are likely to require stringent cost controls.

In those circumstances, a risk-sharing approach to cost overruns may appeal to both parties, encouraging the contractor to stick to its estimate, whilst also allowing some flexibility to deal with unpredictable costs. Options for such an arrangement would include:

  • A shared pain / gain mechanism, rewarding the contractor for coming in below its target cost (i.e. its estimate), but requiring it to bear some of the cost increase if the estimate is exceeded; or
  • Provision for fixed prices, but with a mechanism to adjust them for inflation.

Parties negotiating construction and engineering contracts have great flexibility regarding the commercial terms they agree. Devising creative solutions to the current inflationary environment, to meet the concerns of all parties, is the immediate imperative.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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