Choosing the right contract for a project is vital to ensuring delivery, client satisfaction, and profit success. Construction contracts are the legal contract between a building owner and contractor to build a structure. The two parties use this contract to define the obligations of each party, as well as when compensation is due for damages or costs.
In this article, we’re going to take a look at the commonly used types of construction contracts that you need to understand before bidding on a project.
What Is A Construction Contract?
A construction contract is a legally binding agreement between a project owner and the general contractor. As a rule of thumb, a construction contract should contain the scope of work, timeline, compensation, and various legal clauses. It must also clearly define each party’s rights and responsibilities. It is absolutely necessary for projects to have a contract because this protects the owner and the contractor against non-fulfillment of obligations.
Contracts are also required for construction liens. A construction lien is a type of claim that is submitted by a contractor for clients that don’t fulfill a construction contract agreement. It protects you from the risk of not being paid for the work, labor, and materials supplied for in a construction project.
Factors such as project complexity, risk, budget, deadlines, and payment terms are all considered by clients when choosing the type of construction contract to use.
The 5 Main Types Of Construction Contracts
When it comes to construction contracts, there is no one-size-fits-all approach, as construction projects vary widely in complexity and size. Since a contract is legally binding, general contractors need to understand the ins and outs of each contract type. Entering into a contract not knowing its pros and cons can expose your firm to unnecessary risk and financial challenges.
Also known as fixed price contracts, these are the most popular type of construction contract due to its simplicity. As its name implies, there is one fixed price for all the work done under a lump sum contract.
Lump sum contracts are ideal for projects with a well-defined timeline and scope of work. It’s because lump sum contracts are built upon a clear understanding of the work that is required for a job to be fulfilled. The inverse is also true; if these obligations and expectations are not clearly defined in your contract, scope and budget creep can threaten to eat into your profit margin.
Payment for lump sum contracts is typically staggered throughout different stages of the project. When entering into this kind of contract, it is the general contractor’s responsibility to price everything accordingly, and it is common practice to charge a higher fee for the additional risk you are taking on.
Cost-plus contracts are based on a cost reimbursement model. Clients reimburse the general contractor for all the costs incurred throughout the construction project plus a certain fee to cover profits and overhead. For this reason, close monitoring from the owner is required to avoid incurring excessive expenses. The biggest appeal of cost-plus contracts is that projects under this contract are more likely to fulfill the specifications, and the client’s preferences because contractors will have more resources available to them. Owners who are more interested in getting exactly what they want rather than sticking to a strict budget are best suited for cost-plus contracts. On the flip side, the added flexibility from a cost-plus contract means that clients assume a larger chunk of the risk.
Types Of Cost-Plus Contracts
Cost-Plus Fixed Fee - the contractor is paid a fixed fee that covers their profit apart from the actual cost of construction.
Cost-Plus Fixed Fee With Guaranteed Maximum Price (GMP) - the client agrees to reimburse the contractor for materials, labor and the contractor's fee that covers profit plus overhead. The GMP contract puts a cap on the price that the contractor should charge. Anything beyond this price will be the responsibility of the contractor to pay. A GMP contract also typically includes a clause relating to the unspent balance of the contract. The clause stipulates that any unspent balance is split between the client and the contractor. This incentivizes contractors to work efficiently and stay under-budget.
Cost-Plus Fixed Percentage - the contractor is compensated based on an agreed percentage of the overall contract price.
Time and Materials ContractsThere are instances where project specifications may not always be clear at the start, for this purpose a time and materials contract can be beneficial, especially for smaller residential projects.
Similar to cost-plus contracts, time and materials contracts require clients to reimburse the contractor for expenses incurred from materials and labor. These costs are usually paid at set intervals. For labor costs, hourly or daily rates are agreed upon before any work commences. To incentivize efficiency, it is common practice to include bonuses for completing the project earlier and under budget. Accurate tracking of expenses is the responsibility of the contractor as this will be the basis for reimbursements. Failure to record expenses means that the cost is absorbed by the contractor.
Unit Price Contracts
Unit price contracts are also known as measurement contracts. In this arrangement, contractors divide the total work required to complete a project into separate units with corresponding estimates for each. The estimated price is thus determined by these units rather than having a total price for the entire project. This construction contract agreement gives the project flexibility to accommodate unexpected changes during the course of the project. A great plus for unit price contracts is that it easily allows contractors to bill for additional units.
Guaranteed Maximum Price Contracts
Guaranteed maximum price contracts provide a limit to project costs for buyers. GMP contracts are agreements with contractors that specify a maximum price that a client will pay for the contract sum.
If the actual project cost is higher than the guaranteed maximum price, then the contractor must shoulder the excess out of their own pocket. In the event that the cost of the project is less than the GMP, the contract should state whether savings will be shared between the contractor and the client or whether the savings will go directly to the contractor.
GMP contracts are especially suited for design and build projects since the contractor is involved from design to construction. Being able to oversee the project from conception puts them in a good position to provide value engineering and control costs from design through construction.
Construction Contract Best Practices
Regardless of which construction contract is chosen for a project, these are some of the industry best practices that apply to all construction contract agreements.
Define Clear Expectations
Carefully review construction contracts to identify any gray areas and ambiguous items. It’s the responsibility of the general contractor to make sure that what’s expected of them is well-defined or else there could be a lot of misunderstandings from both parties.
As a contractor, don’t leave any item open for interpretation. Poorly defined clauses and provisions are a major risk item that should immediately raise red flags.
Outline Contingency Plans
Anything can happen in a construction project especially when it spans over the course of many years. Contracts should clearly state risk management measures that are in place to address scenarios that could derail a project’s progress. A contingency budget is allocated for such risks and this must be stated as a fixed sum or percentage of the cost on the contract. Your contingency plan should identify critical areas such as incomplete designs, payment default, environmental disturbances, price increases, labor shortages, and subcontractor default.
Establish Methods Of Communication
Lack of communication is one of the biggest roadblocks to a successful project. General contractors must specify when and how communication takes place between the parties. Because a construction project has many things going on at the same time, it's easy to lose track of details when these are not regularly communicated throughout the project team. An effective construction contract establishes a system of communication and makes it clear to whom questions and updates should be directed.
Specify How Changes Are Handled
Construction projects are notorious for going over budget and extending beyond deadlines. Surveys amongst construction professionals show that around 9 out of 10 projects experience time overruns or delays. Changes in scope are one of the major causes for these delays. Because changes are inevitable in a construction project, contracts should outline exactly how changes are to be made, which stakeholders are involved, and the proper process. Provisions that outline how changes are handled go a long way in helping you avoid costly disputes down the road.
Leverage AI for your Estimates
A pipeline filled with contracts is the lifeline of any construction business. These contracts are based on estimates that take up considerable time and resources.
Savvy general contractors are using AI estimating software likeTogal.AIto speed up their takeoff process leading to more bids that are approved. On-time and accurate bids produced by Togal.AI help increase your company’s chances of being awarded more contracts. With a few clicks of a button, accurate takeoff reports are done in a matter of seconds. Learn how easily Togal.AI integrates into your current estimating workflow. Book a demo today.