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Case Studies in Determining the Contractor’s Allowable Costs and Profit after a Termination of a Construction Contract for Convenience

Determining Responsible Damages Payable to the Contractor

Without a contract termination clause, a contractor that is terminated during the completion of a construction project is due “the benefit of the bargain.” This means that if the contractor’s cost estimate is deemed reasonable, the entire unpaid amount of anticipated project profit, along with incurred costs to produce and terminate the work in process—including project preparation and materials procurement—becomes payable by the owner. The question that must be answered, and which the contractor must be willing to provide complete financial documentation in support of, is: “How much profit did the contractor anticipate to earn from the complete and successful prosecution of the project?”

Before this profit can be determined, the owner should determine an as-accurate-as-possible evaluation of the percent and dollar value of the contractor’s properly completed work at the time of termination. If any work was in need of remediation, the owner should determine the cost of remediation and reduce the amount payable to the terminated contractor.

Notwithstanding potential remediation costs, the contractor must prove the amount of anticipated profits for the project. The most useful source of this evidence is if the contractor has surety bond requirements or a large bank borrowing arrangement, it is likely required to have annual CPA-prepared financial statements—either reviewed or audited. In the construction industry, common practice is to include in the financial statement presentation certain “supplemental schedules”: Operating Expenses, Completed Contracts, and Contracts-In-Process. The Contract-In-Process schedule identifies the estimated cost and profits anticipated by the contractor for each project being completed in the given year. This statement becomes the means by which the CPA can determine the percentage of completion for each of the contractor’s projects and, therefore, the amount of revenue the contractor may recognize for the period. Because it is prepared by an external, independent third party, this statement frequently becomes the most authoritative means for the contractor to support its anticipated profit on the terminated project.

In the event the contractor does not have the supplemental schedules prepared with its annual financial statements, the owner should be provided with the contractor’s bid estimate (tender) to determine the anticipated project profits at bid time, in terms of both dollars and percentage of contract revenue. Regardless, the reasonableness of the bid needs to be verified and proofed against the contractor’s actual performance. A straightforward case study of this anticipated profit calculation includes the reduction for profits that have already been recognized through project progress and the remaining anticipated profits payable to the contractor, as shown below.

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