Need to Know: Five Types of Construction Contracts and Which One is Best For Your Project
Perhaps the most fundamental consideration for any construction project is selecting the type of contract that will govern the project. Construction contracts define the rights and duties of all parties involved. Each type of contract has its own unique features, risk, applications and payment structures. In this post, we explore five common types of construction contracts.
Understanding Different Types of Construction Contracts:
- Lump Sum Contract:
Also known as a fixed-price or stipulated sum contract. Here, the contractor agrees to fulfill its work under the contract for the stated amount. In situations where a contractor experiences financial hardship or project difficulties, the contractor must rely on the remedies defined in the contract such as change order or unusual circumstances clauses. This contract type is ideal for owners who desire to know the total construction cost prior to entering into an agreement. Based on the aforesaid, the lump sum contract type places the greatest risk on the contractor rather on the owner. This contract type is ideal for projects with well-defined construction drawings/documents that accurately describe the scope of work at the time of the bidding and contracting process.
- Unit Price Contract:
Unit price contracts are commonly used in projects where the quantities of work components can be estimated in the preconstruction process, but the exact quantity remains unknown until construction completion. Examples of projects that may typically select unit price contracts are road construction or utility installations. This contract type specifies the price per unit of measurement, such as cubic yards of excavation or per linear foot of erosion control. The contractor agrees to perform the quantities of work actually encountered at the contemplated price within the contract. For this reason, it is common for the owner to have personnel on the construction site to verify actual quantities encountered. The contract allows the owner the opportunity to compare competitive bids with ease during the bidding process and allows for easy adjustments based on project conditions during the construction process. Unlike the aforementioned lump sum contract, the owner will not know the final cost of construction until completion of the project.
- Cost-Plus Contract:
In a cost-plus contract, the owner agrees to reimburse the contractor for the actual costs incurred during construction, along with an additional fee (either fixed or percentage based) for overhead and profit. This type of contract is normally negotiated between an owner and contractor (in lieu of being competitively bid) and is often preferred when construction drawings/documents are not fully complete or do not accurately describe the various scopes of work. Most cost-plus contracts are open-ended and thus the owner will not know the total cost of the work until construction completion. Ideally, the contract will detail the subcontractor-letting process (e.g. how many subcontractor bids to obtain for a scope of work), the billing process (timeliness, steps for reimbursement, what costs are reimbursable, and record keeping), and what is included within the project fee(s) and how the fee is precisely to be paid to the contractor. For the reasons noted above, this contract type places the greatest amount of risk on the owner; especially if the basis of payment is cost of the work plus a percentage fee as this model does not incentivize the contractor to reduce costs.
- Time and Material Contract:
Ideal for projects with uncertain scopes or incomplete construction documents, time and material contracts are often open-ended and thus the owner will not know the final cost of construction until completion of the project. However, the contract can specify a not-to-exceed amount. The owner pays the contractor based on the time spent on the project (i.e. labor hours) and the material costs incurred, along with a predetermined markup for profit and overhead. While this type of contract offers flexibility, it can also lead to cost overruns if not managed effectively.
- Guaranteed Maximum Price (GMP) Contract:
A GMP contract is often used in conjunction with a cost-plus contract. It establishes a maximum price for the project, protecting the owner from cost overruns. If the actual costs are lower than the maximum price, the owner benefits from the savings. A GMP contract can act as a safety net for owners who are wary of the risks of a standard cost-plus agreement. Furthermore, any cost overruns beyond the agreed-upon maximum are the responsibility of the contractor.
Maximizing Project Success: Choosing the Right Construction Contract and Consulting Experts
Choosing the right construction contract is crucial for the success of any project. Understanding the different types of contracts available and the respective advantages and disadvantages can help owners, contractors, design professionals and subcontractors make informed decisions. It is essential to consult legal and construction professionals to determine the most suitable contract type based on project size, complexity and risk tolerance. By selecting the appropriate contract, project entities can minimize disputes, ensure clarity and achieve successful completion.
To learn more about VERTEX’s OPM and additional Project Advisory services or to speak with an expert regarding a construction claim, please contact Grant Hoey at firstname.lastname@example.org or Ryan Gallup at email@example.com.
Richard H. Clough, Glenn A. Sears, S. Keoki Sears. Construction Contracting: A Practical Guide to Company Management, Seventh Edition, Chapter 6.