Types of Construction Contracts: Key Considerations for Owners and Contractors

A construction contract sets out the relationship between a party who wants something built (typically, the owner) and the party who will do the building (the contractor). While construction contracts have many similarities with contracts utilized in other contexts, construction contracts are unique in that it is almost a certainty that the underlying project will encounter unexpected issues beyond the control of either party.

Dealing with these unexpected issues, whether they are unforeseen conditions, delayed material deliveries, bankrupt suppliers, etc., will almost always require additional time and expense. It is important that construction contracts incorporate a clear pricing model and explicitly deal with which party will be responsible for the cost and time implications so that the project can continue uninterrupted and so parties do not have to incur additional time and expense resolving disputes.

Most construction contracts can be separated into five distinct types of pricing models:

1. Lump sum or fixed price contracts
2. Time and materials
3. Unit Price
4. Guaranteed Maximum Price
5. Cost-Plus Contracts

Each of these types of construction contracts have its advantages and disadvantages. Some are better suited for certain types of projects and less suited to others. Selecting the right contract for your project is important to help reduce risks, protect your financial interests and maximize your revenue and 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. These are the most basic and most common types of construction contracts.  Lump sum contracts are best suited for projects with a well-defined scope of work so that the contractor is able to make an accurate estimate of the project’s costs.

A contractor entering into a lump sum contract will want to give special care during the costing and tendering phase, as a well-calculated tender can lead to higher profit margins. On the other hand, any unaccounted for or unforeseen costs can cut into a contractor’s profit margin. Owners benefit from lump sum contracts because they give certainty that construction costs won’t balloon due to unforeseen circumstances. Another benefit is that owners can easily compare and chose among various tenders. A possible disadvantage to owners is that since the final cost is set in stone, contractors may be tempted to cut corners in order to increase their profit margins which may require additional site supervision and increased inspections over the course of 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. These types of 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, work 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 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 increases. However, contractors must be careful to accurately calculate the 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.