Pricing Construction Contracts under Tax Reform Act of 1986

Abstract

Construction business failures increased from 0.20% in 1979 to 1.12% in 1984. To improve profitability, fair and reasonable markup (FaRM) was defined as the smallest markup satisfying required rate of return (RRR). The Tax Reform Act of 1986 (TRA '86) reduced income‐tax rates. In return, TRA '86 removed many tax shelters and loopholes. Construction is most affected by restrictions placed on the completed‐contract accounting method. Managers need new techniques to consider taxes explicitly. The before‐tax‐RRR method makes no provisions for income taxes in cash flows. Instead, it employs a before‐tax RRR high enough to yield the desired after‐tax RRR. The tax‐adjusted‐FaRM method directly adjusts FaRM estimated in a tax‐free world. The FaRM pricing model enables contractors to make better decisions. Instead of using subjective markups that may overlook income taxes, they may bid lower on projects offering more favorable cash flows or lower risks. This results in lower costs to owners while satisfying contractors' RRRs. Conversely, contractors can maintain RRRs on less favorable projects by bidding higher prices.