By: Sydney Paschall on November 9th, 2022
Types of Construction Contracts: What You Need to Know
What is a Construction Contract
While talking about construction contracts and their importance may seem like a repetitive topic, it is one of the most important aspects when considering the construction industry and the success of key players. A construction contract is the method by which terms, conditions, and the fine print of a project and agreement are legally bound together. The contract is a solidified deal made between the parties (usually two—the owner and the contractor) involved in the specified project.
The Importance of Construction Contracts
A means to protect the rights of both the client/owner and the contractor, a construction contract typically contains specifications on the definition of the project, the rights and duties for each party, compensation and how it will be distributed, conditions (general and specific), as well as delay terms and other outstanding provisions that are required for to each party to complete the job successfully.
Not only does a contract outline all of the above and more, but it is also a way for the involved members of the project to be held accountable for their end of the deal. A legally and financially binding agreement between the owner and the hired general contractor(s), subcontractor(s), suppliers, and more. Construction contracts are an absolute necessity for any successful business in the industry, and there are four main types of construction contracts primarily implemented depending on the type of project and payment method.
Common Types of Contracts in Construction
Unit Price Contracts
One of the most implemented types of construction contracts is the unit price contract. This price-based contract sums the total price of the project based on each item unit’s projected cost. The risk is split more evenly between the contractor and the owner, where the contractor is paid according to the rates for each item in the bill of quantity. The unit price option also allows for more flexible changes in design, as the total cost of the project is still unknown as the project can be started before designs are even finalized.
Pros: great for work dependent on default rates, more equal risk between two parties, bidding can be quick and relatively painless, the unit process is competitive, and it is easier to adjust prices for changing scope of work
Cons: more difficult for projects with a high volume of materials and tasks, the total cost is unknown, reporting and managing is more difficult, and some delay in payments can happen
Lump Sum Contracts
Another price-based contract option, the lump sum contract bases the project total on the total fixed price for all activities. This type of commercial construction contract places almost all of the risk on the contractor as they are the ones who will estimate costs from the plans and factor in additional overhead and profit to determine the total value. This does, however, give them more incentive to finish early and possibly receive a greater profit.
Pros: may have incentives and benefits for finishing early and/or under budget, bidding and selection process is easy as only one sum is submitted, and minimal change orders
Cons: all risk falls on the contractor, and change orders are required when there are significant alterations to the scope of work
The cost-plus contract option is when the parties involved have an agreed-upon amount or percentage that covers the builder’s overhead on any particular project. The project owner, who assumes the majority of the risk, then reimburses the contractor for the costs incurred plus an added fee, but only after carrying out the work. There are different types of cost-plus contracts, including fixed percentage, fixed fee, and guaranteed minimum price (GMP). This contract is commonly used by government agencies.
Pros: typically a higher quality of work since the contractor uses the best materials, contractor assumes the least amount of risks, especially if building materials increase in price, ideal when the scope of the project is unknown or in the early stages as the contractor can start before the design is finished
Cons: all risk is on the owner, challenging to compute a final estimate of the project, more oversight is necessary, and less flexibility in decision making
Target Cost Contract
The target cost contract method is a blend of measures found in lump sum and cost-plus contracts. A joint effort between both parties on an agreed amount target cost, the contractors are paid based on actual costs plus a certain fee (usually a fixed percentage) of the total cost. Higher risk can be carried by the contractor in the case where project prices can increase in total cost. However, the contractor can also be rewarded with a percentage of savings between the target cost and the actual cost.
Pros: shared risk between both parties, rewards for contractors for the difference in target versus actual cost, and the target cost is defined at an earlier stage as a mutual decision between contractor and owner
Cons: limited flexibility in changes to design, often takes more time to negotiate, and going over budget
How to Determine the Contract for Your Needs
When deciding the type of construction contract for your specific project, it is essential to understand the types of contracts and the possible benefits and downfalls of using each one. Construction contracts are on a complete case-by-case basis, depending on the amount of labor, materials, equipment, and scope of work for the project. Is it also important to assess the risk factors for each party involved that are associated with each contract type—whom do you want the risk to fall on, or do you want it to be a more even split?
At the end of the day, construction contracts are a vital and integral part of making sure projects are completed as fairly and smoothly as possible. They are comprehensive ways to lay out every minute detail of the project, making sure to decrease the risk of costly mistakes on all sides of execution. It also gives the entire team working on the project a framework to work on and work towards, together.