A construction contract is a legally binding contract between an owner and a builder that defines compensation and how that compensation will be distributed during or after the completion of a construction project. Construction contract types are typically identified by the manner in which disbursement will be made, as well as the duration of the project. These contracts contain a series of documents that outline the work to be completed. These include a scope of work, a construction schedule, general conditions, any special conditions, a cost estimate and drawings. These contracts may also include a bill of quantities, which is a document that lists the materials that will form part of the construction. This is typically presented in the form of an itemized list that includes the cost of materials, parts, and labor that will be used during a construction project. The construction contract will also likely include a list of construction insurance coverage. This is a guarantee to the owner that the contractor has the economic backup to perform the contract. This may include different types of coverage, but typically features general liability insurance, builder’s risk insurance and performance bonding.

There are several types of construction contracts in the industry, but there are four commonly used contracts that can be customized to fit the needs of a particular project or relationship.

Lump-Sum/Fixed Price Contracts

The first is the lump-sum or fixed price contract. A lump-sum contract is typically used in the construction industry to reduce design and administration costs. In this contract, the contractor is required to submit a total price (a lump-sum) rather than bidding on individual items. This contract is often used on small or simple projects with a well-defined scope of construction. Or, where there the risk of different conditions is minimal.

In a lump sum contract, the owner agrees to the contractor’s price and then assigns the risk to the contractor. A lump-sum contract is formulated by estimating labor and material costs, and it also includes any overhead or profit margin.

Projects where a lump-sum contract are ideal are undertakings that are well-defined and the plans and construction drawings are complete. It is the preferred choice for smaller projects, or projects where assessments in such aspects as soil conditions have been analyzed by the contractor or engineers.

The lump-sum contract has advantages. These advantages include low risk to the owner and a fixed construction cost. This contract is widely accepted and the bidding analysis and selection process is typically relatively simple. For a contractor, the owner supervision is reduced, as opposed to a Time and Materials contract. And, to the owners benefit, a contractor may try to complete the project faster with maximized production.

There are disadvantages to the lump-sum contract. First, there is a greater risk to the contractor as there is always the possibility of unforeseen conditions. In a lump-sum contract, the project should be completely designed beforehand. Here, the construction process could take longer than anticipated but with no financial coverage. For the owner, in the lump-sum, the contractor will typically select their own methods, so the owner may have less oversight. The most common disputes to arise from a lump-sum are unbalanced bids and scope and design changes.

Time and Materials Contracts

Time and material (T&M) contracts are typically undertaken when the project scope is unclear or a timeline has yet to be defined. In these contracts, the owner and the contractor agree upon an hourly or daily rate, as well as a fee for additional expenses that may arise during the construction process. This type of contract is used when it may be difficult to create an accurate estimate for the total project cost or how long a project will take to complete, or if changes are likely to occur during construction. This type of contract is high-risk for the owner and lower-risk for the contractor.

T&M contracts typically involve a number of negotiated elements. In a T&M contract, the owner can set a maximum agreed upon number of labor hours where the contractor is not to exceed those hours. If the contractor exceeds those hours, the additional hours cannot be billed to the owner. This prevents the contractor from slowing production to make more money. In addition, a T&M contract may also have a not-to-exceed financial cap, which represents the maximum amount that can be charged by the contractor for the project in full. A T&M contract will also include a negotiated labor rate. Here, the owner and contract agree upon a fixed rate for all labor, which includes administrative individuals.

There are disadvantages to the T&M contract. For a contractor, owners may attempt to negotiate strict not-to-exceed financial conditions that may have a negative effect on a contractor’s profit. Also, with a lump-sum contract being more popular, many owners and contractors are not used to working with T&M contracts, which may make finding new opportunities difficult.

Cost Plus Contracts

A cost plus contract is a contract in which the contractor gets paid for construction related projects plus a profit. These contracts are typically used when the scope of the project has not been clearly defined or there is not enough data to perform a detailed estimate of the work. Cost plus contracts are typically viewed as a very advantageous contract for the contractor. Many government agencies prefer this type of contract as it gives them the opportunity to select a contractor based on qualifications instead of the lowest bid to come in. Some of these contracts can be customized with a “not-to-exceed” stipulation.

There are three main factors that are considered in a cost plus contract. The first is direct costs, which include the labor, materials, equipment, professional consultants (if applicable) and supplies. Second, the overhead costs are estimated. This includes business related expenses, such as office rent, insurance, communication, mileage, etc. And then third, the cost plus includes a fee/profit, which represents a fixed percentage based on the labor costs associated with the work.

A cost plus contract may be used when a budget is restricted or if there is a possibility that actual costs may be reduced. Advantages of this type of contract include a minimized risk to the contractor, quality is the focus over cost and the contractor will not be able to reduce workmanship. However, there are also disadvantages to this contract, including the uncertainty of the final cost, the additional resources required to justify costs and longer than expected project times.

Unit Pricing Contracts

The unit pricing contract is a contract in which unit prices guide the compensation. Unit pricing contracts may occur after a contractor is hired, or they may be used to receive bids during the bidding process. During the bidding process, the owner may request contractors submit their plans based on pricing for specific quantities of materials. This contract is advantageous for the owner, as the owner can verify that he or she is not being overcharged for inflated supplies. And, these contracts may carry with them a stipulation that the unit prices can be adjusted during the scope of the project, making it easier for the contractor and owner to agree on change orders.

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