The 3 Most Common Types of Construction Contracts

Nov 9, 2024

You’ve finally made the decision: you’re ready to turn your property into an investment. After exploring residential, commercial, and industrial options, you’ve found the one that feels right. Eager to start this journey, you’re ready to just sign a contract and get started. But, it’s not that simple.

It’s important to understand that there are several types of construction contracts, each with its own pros and cons. Familiarizing yourself with these contracts can help you determine the best fit for your investment. However, with the vast amount of resources available, we know how overwhelming it can be to research every single contract.

To simplify the process for you, we’ve distilled the information into the three most common construction contracts: fixed-price contracts, cost-plus contracts, and guaranteed maximum price contracts. Let’s break them down so you can determine the best contract for your investment.

Construction worker marking up project blueprints

1. LUMP-SUm contracts

A lump sum contract, also known as a fixed contract or a stipulated sum contract, is the most common type of construction contracts. This contract provides the client a fixed price for all materials and labor required to complete a project. Many opt for this option because both parties understand the budget and expectations clearly. Of course, this is only if the client provides a well-defined scope of work (SOW) to the contractor. It is important to provide a detailed SOW, so contractors can make an accurate estimate of the project’s budget and timeline. A detailed SOW includes plans, specifications, and timelines, which help prevent misunderstandings later on.

Pros

The price of the project is fixed, so it does not increase due to unplanned circumstances
Reduces the risk of dispute over project details since it requires a well-defined SOW
The contract is straightforward, reducing the complexity of negotiation and project management
Payments are often made at predetermined milestones, which helps both parties manage their cash flow
Since the contractor bears the risk of cost overruns, clients can focus on other aspects of the project

Cons

If the initial scope isn’t well-defined, contractors may provide higher estimates to cover potential risks, leading to a higher overall price
The fixed-price nature can discourage open communication and collaboration between the client and contractor
With a fixed final cost, contractors might be inclined to take shortcuts in order to increase their profit margin
Projects with high complexity can encounter significant challenges as it’s hard to accurately predict costs
There is limited flexibility, so any changes from the original SOW requires a change order paid by the owner

2. Cost-Plus Contracts

A cost-plus contract is an agreement where the project owner reimburses the contractor for the project’s actual costs plus a predetermined markup. This arrangement requires the contractor to provide a detailed estimate of anticipated costs, which the owner must approve before signing the contract.

What is included in costs & markup?

1. Project Costs: The project cost will be specified by the contractor and property owner before signing the contract. These costs typically include indirect and direct costs.

Direct Costs

Expenses that can be directly attributed to the project, including labor, raw material, and equipment required to complete the project.

Indirect Costs

Project overhead costs such as transportation, office rent, insurance, and utilities.

Note: A cost-plus contract covers all direct costs. Indirect costs are usually calculated as a percentage and can vary depending on the size and length of the project.

2. Contractor markup: The contractor markup is often calculated by a negotiated percentage of the total cost of the project. The percentage can vary depending on the type of project, the complexity of the work, and the risk involved. A few other common arrangements include:

- Fixed Fee: The contractor receives a flat fee that’s determined during contract formation.
- Incentive Fee: This structure rewards the contractor for meeting specific performance targets. For instance, a contractor is hired to build a commercial office and can earn an additional 5% bonus if they complete the project two months ahead of schedule.
- Award Fee: Here, the contractor receives extra compensation for exceeding performance expectations. For example, a contractor working on a public park project might receive an award fee if they finish the job with high-quality finishes and within budget

Pros

These contracts work well when the full scope of the project is uncertain or complex, as they allow for ongoing modifications
Clients have access to detailed records of all costs, which promotes transparency
Contractors can focus on quality rather than cutting corners to stay within a fixed budget
Encourages a cooperative relationship between client and contractor
Contractors are incentivized to use quality materials and labor since they are reimbursed for allowable expenses

Cons

Clients may face unpredictable final project costs
The ease of making changes may lead to uncontrolled project scope expansion, impacting timelines and costs
Requires extensive documentation and tracking of expenses, increasing the workload for both the client and contractor
Costs can escalate significantly if not monitored closely, leading to disputes over what is considered allowable
Contractors may not prioritize cost control since they are reimbursed for all expenses

3. Guaranteed Maximum Price (GMP) Contracts

While having all of the same terms as a cost plus contract, the GMP adds an additional agreement of establishing the gross maximum price. A Guaranteed Maximum Price (GMP) contract is just as the name implies: it establishes a maximum price the owner is willing to pay the contractor for completing a project. It’s important to note that if the contractor exceeds this price limit, they will have to pay out-of-pocket.

This contract requires a clear SOW and project costs that will not change drastically over time. To help manage potential financial risks, both the owner and contractor typically determine the contract price before-hand based on three key factors:

Direct and indirect project costs
Contractor profit markup
A financial reserve for unforeseen circumstances

In this arrangement, the general contractor serves as a Construction Manager at Risk (CMAR). This means the contractor is responsible for overseeing the entire project from start to finish, ensuring that it stays within budget and meets the specified requirements.

Pros

Owners do not have to worry about costs exceeding the agreed maximum price
Change orders are minimized since project plans are finalized before construction begins
The close collaboration between the owner and contractor leads to improved communication, which can enhance project outcomes
Contractors may seek innovative methods to stay within budget, leading to potential improvements in construction practices
Since the contractor bears the risk of cost overruns, clients can focus on other aspects of the project

Cons

Requires careful planning and detailed project specifications, which can lead to a more complex contracting process
Can result in higher initial prices compared to other contract types ,as contractors may include additional contingencies to cover potential risks
If a contractor is overly focused on staying within budget, there’s a risk that quality could be compromised in an effort to reduce costs
Disagreements may arise regarding what constitutes direct and indirect costs, leading to potential conflicts between the owner and contractor
There is limited flexibility, so any changes from the original SOW requires a change order paid by the owner

Which Contract is right for you?

Mitigating risk by carefully considering and researching all the pros and cons is the best way to choose the right contract type for your next project. A trustworthy general contractor will go over different contract types that best serve their client.

A recent prospect shared a story that illustrates this point. A general contractor quoted a project at $48 million, which seemed less expensive than other “fixed” proposals. However, as the project progressed, the prospect found themselves 20% over budget due to unnecessary change orders. This not only strained their financial resources but also hurt the overall profitability of the project.

When choosing a contract, weigh the pros and cons carefully, and consider your project’s complexity, your risk tolerance, and how much oversight you’re willing to provide. Engaging in thorough discussions with potential contractors about their pricing structures, past project experiences, and their approach to handling changes can also help guide your decision.

By understanding the strengths and weaknesses of each contract type, you can select the one that aligns best with your vision and financial strategy, ensuring an ELITE construction journey.