Exploring Construction Contract Types
Construction contracts come in various shapes and sizes, with risk being shifted based on which side of the fence you are on. Generally, the Owner will enter into a direct agreement with the Contractor under one of four general construction contract types, all being either fixed cost or reimbursable cost in nature. These include “Lump-Sum” or “Stipulated Sum”, “Cost Plus a Fee”, “Cost Plus with a Guaranteed Maximum Price (GMP or GMAX)” and “Unit Price”. One might ask, what drives the selection of these different types? Generally, the following do:
- Project Delivery Method
- Whether a Job is Competitively Bid or Negotiated
- Risk Allocation
- State of the Design information
- Type of Project
In this blog we will dive into the various contract types and the pros and cons related to such.
Lump Sum/Stipulated Sum
A Lump Sum (or Stipulated Sum) contract, in simple terms, is when the scope of the work to be provided by the Contractor and the cost of such is known and agreed upfront. This contract tends to be riskier for the Contractor as they have agreed a set price for construction up front, and the Contractor is responsible for completing the scope for the price agreed upon; if they do not, then they are responsible for any cost overages that are not the result of valid design changes and unforeseen conditions (where the contract sum would be increased via Change Order). The Contactor’s profit or loss is as simple as the agreed lump sum amount less their actual cost to complete the scope. It is important for the Contractor to analyze the site and design information thoroughly to ensure its estimates, schedule, labor force, etc. are accurate because if they are not, their profit will be negatively affected. Given such risk, it is not uncommon for the Contractor to inflate their costs to help mitigate the risks of budget overages (while still staying competitive) or the Contractor may be incentivized to cut corners to increase their profitability. It is also not uncommon for the Contractor to add certain provisions within the contract language to account for risk related to unforeseen circumstances and significant price escalations. These contracts typically work best when thorough design/scope information is known early on and can benefit Owners on a strict budget.
Cost Plus a Fee (With or Without a GMP)
A Cost Plus a Fee contract is a cost-reimbursable contract. Within this type of contract, the fee paid to the Contractor is fixed and guaranteed at the inception of the contract. The Contractor’s fee will typically be a set dollar amount or a set percentage of costs (with or without a cap); though such can be adjusted, if necessary, via change order if agreed by the Owner and Contractor (if, for instance, the total cost and time of the overall contract is increased). This contract type is typically used when the scope is not as defined or if there is potential for multiple change orders. This contract type can be less risky for the Contractor as they are not typically subject to losing profit due to price increases on material, labor, etc. However, the Contractor could still be at risk for budget busts, etc. (i.e. if the buyout of specific trades exceeds the budgeted value set within the GMP budget/Schedule of Values) unless there is an escalation clause included within the contract language. This contract type can also benefit the Owner as they provide more oversight over costs throughout the project. A disadvantage to this contract type is that the Contractor may have less incentive to finish the project efficiently, as the Contractor will receive payment regardless of if the project has been completed in a timely manner. It should be noted that at the initiation of the contract, it is important to establish a maximum amount for material costs and which costs are or are not reimbursable.
A Cost Plus a Fee with a GMP is when a maximum amount of reimbursement is placed on the contract. This allows certain advantages of Lump Sums to be incorporated into a Cost-Plus contract. Additional advantages to this contract type for the Owner include a reduced risk of having the project overbid and typically a higher quality of materials and labor are utilized. For the Contractor, the advantages of this contract type includes the ability to take on projects with scopes that have not yet been fully designed. There also tends to be incentives for the Contractor to complete the work in a timely manner and under budget to help combat the risk of abuse from the Contractor in non-GMP Cost Plus Contracts. With a GMP in place, the Contractor would be paid the lesser of their actual costs plus the agreed fee or the stated GMP value (as adjusted by change orders, when applicable).
A Unit Price contract is utilized when individual portions of the work, individual units or specific materials are priced to estimate the total project cost. Within such contract type, the Contractor is paid for the quantity of each line item performed based on the agreed unit pricing values. Unit Price contracts are commonly utilized for public works projects, horizontal construction, or engineering projects and are best suited for projects consisting of repetitive tasks. These contracts are similar to Lump Sum contracts; however, the Contractor is paid for actual quantities, similar to Cost-Plus contracts. Owners usually face higher levels of risk with Unit Price contracts due to their limited knowledge of the precise quantity of units, which can lead to uncertainty in estimating total costs. The Owners typically provide the project quantities under this contract type; therefore, if the project quantities are incorrect, the responsibility falls on the Owner for the additional costs incurred. Such contract types allow for the Contractor to provide competitive bids, even if the precise project quantities are off. The Contractor must be cognizant of applying appropriate pricing to units as poor pricing can drastically affect their profit.
Tailoring Contracts to Your Unique Project Needs
Each project is unique with its own set of circumstances. When deciding which contract type to utilize for your project, consider the project delivery method, risk allocation, type of project, competitiveness of the bidding process, and the status of the project’s design. No contract is the same and it is important to thoroughly understand the construction contract. Most contracts will also include a clarifications and exclusions section which can mitigate the Contractor’s or Owners’ risk and deter certain advantages of the nature of the contract type, such should be reviewed in detail to ensure there are no negative impacts to the intended design and quality of the project. Each contract type shares its individual pros and cons; therefore, be sure to review all the requirements for your project prior to engaging in a contract. A wise person once said that “a project benefits when risk is fairly distributed between both parties“.