3 Types of Construction Contracts You Need to Know
Modern construction projects are developed through a number of contracts and sub-contracts. This model delivers higher cost and time efficiencies and better quality. But it’s critical to know which contract to use and when. Let’s take a tour of construction contracts and the different types of them.
Construction contracts, to put it simply, are binding legal documents that specify the work that will be done by a general contractor and the payment that will be made by the project owner. They are crucial to the management of construction projects.
However, there is no one-size-fits-all approach when it comes to scheduling contracts in construction because the complexity and size of construction projects vary greatly. Due to this, various types of construction contracts have been developed over time. We’ll look at the following three types that are used more commonly:
- Lump sum or fixed price contract
- Time & materials (TM)
- Cost-reimbursable contracts.
Lump Sum or Fixed Price Contract
Lump Sum or Fixed price contracts are ideal when the requirements are well understood and the scope of the work is clearly defined. The seller is expected to provide a fixed price quotation for the agreed scope of work once the scope has been clearly defined. When putting together a fixed-price quotation, the owner must be aware of both the project’s requirements and all associated risks. As a result, the owner must also be very capable and mature in order to enter into a fixed-price contract.
Once a deal is reached, both parties benefit. When the contractor completes the specified scope of work, the owner is guaranteed to pay a fixed price. Payments will be made after achieving clearly defined results. Once agreed upon, the contractor in this case takes on all cost-related risks. In this type of contract, the contractor may experience financial loss, but if they can complete the work at a lower cost, they may also make a maximum profit.
To make a Lump Sum contract it takes considerable maturity and clarity on the parts of both parties. It might take some time to negotiate. Once finalized, the Lump Sum or Fixed Price contracts will use change requests for any modifications to the scope or other terms and conditions.
One popular variant of the Lump Sum contract is the Schedule contract. The Scheduled contract in construction differs from the Lump Sum contract in that it also includes a Schedule of Rates (SOR) between the owner and contractor. In addition to the lump sum price, the contractor displays a schedule of rates to regulate the additional amount for additional work.
Unlike a lump sum contract, it is important to study every detail of the work thoroughly, otherwise, disputes may arise if additional costs are added afterward.
Time and Material Contract (T&M)
Time and material contracts are a very common type of contract, which is used for routine procurement of items that may include temporary manpower reinforcement as well as all types of materials required for the project. Recruiting manpower is usually done to bring in higher skill sets and expertise, specific to the project.
In T&M contracts (also known as Unit Price contracts), the developer chooses a few preferred vendors for such labor and material supplies. The selection of the vendors will be based on their credentials, capabilities, and experience. For such supplies, a price (or rate) will be negotiated. The total cost will be determined by how many of these resources are used up or bought.
T&M contracts are easy to manage. It involves both fixed-price and reimbursement-based consumption.
Cost Reimbursable Contract (CR)
In a cost-reimbursable contract, the owner has to pay the contractor the actual cost of labor and/or materials plus profit at a predetermined rate. The contract must also clearly specify how indirect costs and general overhead costs are accounted for, in order to determine the total costs incurred.
This type of contract is particularly helpful when accurate estimating is impossible due to erratic site conditions or other factors, such as hazy specifications or it’s unclear as to how a product will be developed. As a result, a CR or cost-plus fee contract puts more risk on the owner and necessitates a high level of trust in the contractor.
Cost-reimbursable contracts are used for innovative research, development, and proof-of-concept projects that demand a great deal of creativity but don’t have a guarantee of success.
Here are a few different types of cost-reimbursable contracts.
- Price plus a portion of the price (CPPC)
- Cost plus a set charge (CPFF)
- Fee plus Incentive plus Cost (CPIF)
- Cost plus honorarium (CPAF)
Cost-plus agreements place all the risk on the owner because the contractor is guaranteed to receive all actual costs as well as the profit. The owner bears the full risk and responsibility. These contracts have a negative side. Given that they are guaranteed to receive all actual costs, the contractor may not be too keen on cost control. This necessitates the owner to conduct auditing and monitor each major expense.
Comparison Between the three main types of Construction Contracts
|Points of Comparison||Lump-Sum Contract||T&M Contract||Cost Reimbursable Contract (CR)|
|Advantage for the contractor||Incentives for early finish||Low risk||No risk|
|Disadvantage for the contractor||High risk||No incentives for early finish||No incentives for early finish|
|Advantages for the owner||No risk
Total cost is defined at early stages
|Share risk with the contractor||Can start a project without finishing designs|
|Disadvantages for the owner||Contractor’s desire to decrease costs may be to the detriment of the quality||Total cost is uncertain at the early stages||High risk
Total cost is uncertain at the early stages
|Operational flexibility||Limited flexibility||Has flexibility to change design||More flexible to design stages|
The kind of construction project (whether it is a dam, road, or civil construction) plus the eligibility and credentials of the contractor play a major role in defining the contract type. The best deal for your business can be negotiated better if you are aware of all your options. Using takeoff software may be a good way to learn and estimate quickly in order to bid more frequently and thereby raise your chances of success.