Types of Construction Contracts: Key Considerations for Owners and Contractors

A construction contract defines the relationship between a party who wants something built (typically, the owner) and the party who will do the building (the contractor). While similar to contracts used in other contexts, construction contracts are unique in that unexpected issues beyond the control of either party- such as unforeseen conditions, delayed material deliveries, bankrupt suppliers- are almost guaranteed to arise.

Dealing with these unexpected issues will almost always require additional time and expense. It is important for cons truction contracts to include a clear pricing model that explicitly outlines the responsibilities of each party regarding cost and time implications. This clarity will help ensure the project runs smoothly and minimizes the risk of dispute that could lead to further delays and costs.

Construction contracts can be categorized into distinct pricing models, each with their strengths and weaknesses. The most common being:

1. Lump sum or fixed price contract
2. Time and materials contract 
3.  Unit price contract
4. Guaranteed maximum price contract
5. Cost- plus contract  

Understanding these options is essential, as the right choice can make all the difference to your project. Some are better suited for certain types of projects, while others may lead to challenges down the line. Selecting the right pricing model for your project not only reduces risks but also helps protect your financial interests and maximize your profits.  

Lump Sum Contracts 

In a lump sum contract, the parties agree on a fixed price for the entire project, phase, or scope of work. This is the most basic and most common pricing model in construction contracts and is ideally suited for projects with a well-defined scope of work, enabling contractors to make accurate project cost estimates.

Contractors entering a lump sum contract should give special attention to the costing and tendering phase; a well-calculated tender can lead to higher profit margins. However, any unanticipated costs can significantly impact profitability.

easily compare various tenders. However, since the final cost is fixed, contractors may be tempted to cut corners to protect their profits. This could warrant the need for additional site supervision and increased quality inspections throughout the project.  

Time and Materials Contracts 

In a time and materials contract, the contractor bills for all material costs and labour at an hourly rate. Typically, contractors will charge for the material costs, which are the actual costs of the materials, applicable transportation and storage costs and a markup charge negotiated between the parties. Contractors will also charge for labour costs which includes base pay for labourers, overhead, administrative costs and a profit margin for the contractor. Time and material contracts are best suited for projects with an uncertain scope.

Time and material contracts offer additional protection to contractors who have greater assurance that their costs will be covered throughout the project and relieves contractors of having to stress about creating a perfect estimate. However, contractors will have to pay special attention tracking and submitting labour hours and material costs which will often require a dedicated administrator or increased administrative costs. Alternatively, time and materials contracts can be less appealing for owners because a total cost of the project is unknown at the start and there is a risk that construction costs become prohibitive. This risk can be managed with the inclusion of a “not-to-exceed” clause that sets a maximum price. 

Unit Price Contracts 

In a unit price contract, the price is divided into fixed cost units and contractors bill for each unit separately. Unit price contracts are best suited for projects with an uncertain number of repeatable elements. Typically, the unit price will include all of a contractor’s costs including labour, materials, overhead and a markup for profit.

Owners must be cautious in that unit pricing can obscure the overall construction costs if the exact number of units is unknown. Unit price contracts allow for simplified billing and tracking and simplify overall contract negotiation. However, contractors must be careful to accurately cost out the unit pricing otherwise they can find themselves in situations where their profit margins are destroyed. 

Guaranteed Maximum Price Contracts

In a guaranteed maximum price contract, the contractor sets an upper limit for costs and will be forced to absorb any additional costs above that limit, which will cut into and potentially erode their profit margin. These types of contracts are beneficial to owners as they provide certainty as to the costs of construction from the outset of the project.

Guaranteed maximum price contracts are best suited for projects with known scope and challenges, with reduced need for change orders. Contractors need to be sure they are accurately costing the projects and submitting well thought out estimates so to avoid costs over runs and having to pay out of pocket costs for the project. 

Cost-Plus Contracts 

In a cost-plus contract, contractors are paid for project costs plus a predetermined profit margin. Typically, direct costs such as labour, materials and specialized equipment are included and indirect costs such as insurance and administrative costs are charged on a percentage basis. Similarly, a percentage or flat fee will cover overhead and profits. These types of contracts are best suited for projects with many potential change orders, such as projects where construction is scheduled to begin before the design has been completely finalized.

Cost-plus contracts are beneficial for contractors because of greater certainty and reduced risk that they’ll be reimbursed even if prices of materials and labour increase. However, contractors must be careful to accurately calculate the correct percentage to cover their indirect costs, otherwise any profit from the contract will have to be used to cover these expenses. Contractors will also be required to meticulously track their expenses in order to submit for reimbursement. On the other hand, project owners might not like the uncertainty of not knowing the full costs of construction ahead of time, however these uncertainties can be accounted for by incorporating clauses that put a cap on cost reimbursement or by incorporating performance bonuses or other incentives that encourage contractors to come in ahead of schedule and under budget. 

The construction lawyers at SV Law can help you understand the risks and benefits of each type of pricing model seen within construction contracts and can provide tailored advice to help you choose the best type of contract for your project.