A Comprehensive Guide to Understanding Different Types of Construction Contracts

A Construction project involves many persons, and a basic document is necessary where everyone’s rights and liabilities are defined for the smooth conduct and successful completion of the project. Such an agreement document is called a construction contract. In this blog, we will unravel the different types of construction contracts, their pros and cons, and learn some expert tips on writing a strong contract agreement.

What is a Construction Contract?

The construction contract is an agreement between the parties involved in the construction project that defines the terms and conditions on which the construction must be completed.

The Construction contract is drafted in such a way that it contains all the

• General conditions of the construction project
• Special conditions of the agreement between the parties
• Details of the construction work
• Specifications of the project work
• Time limits for the completion of the project work
• Payment terms
• Penalties for late delivery
• Resolution of disputes

As such, the construction contract is the basic document on which the entire construction work is executed with a clear definition of the rights and obligations of each one of the parties engaged in the construction work. Hence the construction contract is drafted and executed in such a way that it can be enforced in a court of law.

The Construction Contract is an exhaustive and extensive document that covers and deals with every phase of the construction project. It is prepared based on the following construction documents like –

• General conditions
• Special conditions
• Drawings and specifications
• B.O.Q (bill of quantity)
• Letter of acceptance
• Contractor bid

There are various types of construction contracts in operation to suit each construction project’s uniqueness that have different ways of achieving the result of the successful completion of the construction work.

Selection of Type of Construction Contracts

Every project has its particular circumstances and uniqueness, so it’s crucial to select the contract type which suits the project. The selection of a particular type of construction contract depends on factors like

• Project objectives to be achieved
• Project constraints subject to which the project has to be completed
• Method on which the project must be delivered

Types of Construction Contracts

In practice, we see that construction contracts come in many types with their own advantages and disadvantages. Contracts for construction are mainly divided into two major types depending on the method of payment to be made by the project owner to the contractor or the person who is directly involved in the project’s execution.

They are:

1. Lump-sum contract
2. Unit price contract
3. Cost-plus contract
4. Target cost contract
5. Guaranteed maximum price (GMP) Contracts
6. Time and Materials Contracts

1. Lump-Sum Construction Contract

In this type of construction contract, the contractor works out the quantum of works involved in the construction project and prepares a detailed bid with a single fixed price to complete the entire project activities.

In this type of construction contract, the contractor takes responsibility for preparing the estimation for the entire project costs based on the project specifications and the project drawings and adds his mark–up as his profit, and submits the same as a single bid to the project owner.

When the project owner accepts the bid, the contractor has to complete the project within the price set in his bid, and the project owner has to make the payment of the agreed bid amount as the project cost to the contractor.

Pros of Lump Sum type of construction contract

• Simplicity: this contract is straightforward in outlook as the contractor submits single pricing, the owner accepts the same and agrees to pay it, and the contract proceeds to complete the project based on the accepted price. There are no multiple bids.
• More profit for more efficiency: when the contractor can complete the project under the budget, he gets more profit
• No uncertainties: As all the specs of the construction have been included in the building contract, there are no uncertainties, and the project owner is sure of getting what he wants at a fixed price.

Cons of Lump Sum construction contract

• Not good for the contractor: as there is no flexibility for the contractor’s errors in calculations, and no variables are allowed in the agreed project specifications, there is no scope for revision of the price after commencing the project.
• Missteps and miscalculations will work against the contractor and will eat away his profit.
• No scope for unexpected setbacks or changes during the execution of the project

Hence, this lump-sum construction contract is more suited for smaller to medium types of projects with well-defined and predictable scopes of work.

2. Unit Price Construction Contract

This is a type of construction contract in which the contractor gives an item war project cost to the project owner and undertakes the project upon the condition that he will be paid for each unit of the project on its completion. The contractor gives a detailed break-up of the project, takes each item of the work on a fixed unit cost, completes it, and gets paid for that unit of work.

In this type of building contract, the project’s risk is shared by both the contractor and the owner, and this offers more flexibility to the contractor as there is a good chance of taking care of unexpected setbacks and errors in the construction.

Pros of Unit Price Construction Contract

• Simplified invoicing: as the entire project is broken into smaller units of work with their own pricing, the invoicing of the project is much easier, and this allows more transparent pricing for the project.
• Fewer chances for disputes: as the entire project proceeds on transparent pricing and the outcome of each one of the individual units are well defined, there is no scope for disputes.
• No chance of reduction in profit: the contractor works on a per unit basis with payments well defined for each of the units, and hence more work means more profit, so his chance of loss is minimal

Cons of Unit Price pricing contract

• As the entire project is executed in smaller units, predicting the final value and the result of the project is difficult to predict.
• As the units that are needed to be completed are known beforehand, it may make the owner pay more than the necessary amount.
• There may be delays in making payments as each unit becomes a different project and the measurement and outcomes have to be measured and ascertained for each unit.

3. Cost-plus Construction Contract

In this type of construction project, the contractor is paid as per the project’s actual cost after including direct and indirect costs incurred by the contractor. He is paid a specific fixed fee or a percentage of the total project cost. There are three different types of cost-plus contracts: cost plus fixed percentage, cost plus fixed fee, and cost plus with guaranteed maximum price (GMP) contract.

In this type of construction contract, most of the risk resides with the owner, and he has to be actively involved in the management of the project, as the contractor will not be affected by the errors in the work and is entitled to receive his fixed fee. However, the contractor has to provide the owner with an estimate of costs before the project starts.

Pros of Cost-plus Construction Contract

• Cost-plus construction contracts are especially beneficial when the scope of the project is not well-defined or there are no detailed cost estimates of work.
• A favorable contract type for building contractors, as they have certainty that their costs will be reimbursed even if labor or material prices rise.
• Project owners can set a price cap beyond which costs cannot be reimbursed to the contractor. Also, cost-plus contracts offer owners the flexibility to make design adjustments along the way.
• Specific cost-plus contracts entail performance bonuses or other incentives that motivate contractors to accomplish the project under budget and before schedule.

Cons of Cost-plus Construction Contract

• If the owner doesn’t apply price caps, there is a risk of the project scope going overboard.
• Commercial contractors have to meticulously track all their expenses and justify them in front of the owner for cost reimbursement. Though, expenses such as administrative and transportation costs can be tough to justify.
• Business owners remain unaware of the full costs of their commercial projects.

4. Target Cost Construction Contract

In this type of construction contract, the contractor agrees to complete the project at a target cost, and in return for this, the owner agrees to pay the contractor a fixed or a percentage of the project’s total cost. The three elements counted while estimating a project’s target costs are:

1. Construction expenses – Include costs of the materials, labor, equipment, and other resources.
2. Contractor fees – General overhead, insurance costs, and profit margin.
3. Risk compensation – Funds to recover from the damages caused by either party’s withdrawal from the contract or unexpected project changes.

In this type of contract, the contractor is exposed to risks as he will not get any amount if the project cost exceeds the specified target price. There is a risk carried by the contractor in case of an increase in construction projects cost. The contractor has also rewarded a percentage of any savings between target and actual cost.

Pros of Target Cost Construction Contract

• Both the contractor and the owner share the common goal of minimizing the actual costs. This also results in fewer claims and easier settlements.
• As the contractor owns a stake in the project’s final budget, they strive to keep expenses low, complete deliverables faster, and build a high-quality end product.
• Indefinite budget estimates in target cost contracts offer a high level of design flexibility to the owners and developers.

Cons of Target Cost Construction Contract

• The contractor may have to share cost savings with the owner, similarly, the owner may have to share the loss of overruns with the contractor.
• In an attempt to maximize their profits, the general contractor might utilize low-quality cheaper materials or resources.
• Target cost contracts depend on estimates of the scope, schedule, and cost of the project. So, any last-minute changes can make it difficult to accurately establish the final cost.
• Since profit and loss of both contractors and owners rely on the commercial project’s success, disputes may arise over the scope, costs, and risk allocation.

5. Guaranteed maximum price (GMP) contracts

In this type of construction contract, there is a cap on the project price, and the contractor has to complete the project within this price range; if he is not able to complete the project within this price, then the contractor has to bear the extra cost to complete the project.
This type of project is good for projects with fewer or no unknowns.

Pros of GMP contracts:

• Guaranteed price as there is a cap on the maximum amount the owner is willing to pay for the contract
• Shorter bidding time as the process of the project and pricing are well known.
• Incentivize the savings in the execution of the project, and hence there is a higher performance level.

Cons of GMP contracts

• Riskier for the contractors as there is no flexibility to compensate for overages
• Requires more time to review and negotiate

6. Time and Materials Contracts

This type of construction contract is used in cases where the scope of the project cannot be defined easily. In this building contract, the contractors are reimbursed for the cost of the materials used by them along with payment for the labor based on an hourly or daily rate.

Pros of T&M

• It covers the uncertainties as there is payment for the materials and labor used in the project.
• Simple and faster negotiations as the type of materials to be used alone are to be discussed and finalized.

Cons of T&M

• Time-consuming process: tracking of time worked, and materials used is a time-consuming and long process
• Prone to disputes: as the payment is based on the use of material and labor, which is hard to track with accuracy chance for disputes is there.
• No reward for performance: this type of contract does not provide for any extra payment for early completion, and there is an incentive for high performance or early completion of the project.
• The considerable risk for the owner as he undertakes all the uncertainties connected with the project.

7 Expert Tips for Writing Construction Contracts

An ideal commercial construction contract agreement must be thorough and clearly define terms and conditions of the participating parties. Here are seven expert tips on how to write a construction contract.

Tip 1 – Break the contract down into key points and clearly outline expectations for cost reporting.
Tip 2 – Add the fundamental elements in the contract agreement: contact information, project scope, timelines, payment schedules, warranty, etc.
Tip 3 – Mention the standard clauses based on your requirements, e.g. liability clause, insurance and indemnification clause, arbitration clause, termination clause, or some other clause.
Tip 4 – Make change orders in writing. This way you can keep a record of additional work and its related costs after both parties sign the initial contract.
Tip 5 – Specify the means and regularity of communication between both parties.
Tip 6 – Include your contingency plans and any project-related incentives in the agreement.
Tip 7 – Hire a professional California construction contracting lawyer who is well-versed with the state’s statutes and regulations to ensure your contract complies with them.

Always use easy-to-understand and concise language while writing the construction contract agreement so that all the parties can absorb the contract details.

Conclusion

Thus there are many types of construction contracts, and you have to carefully choose the one that is capable of assuring the best results to you at the best possible pricing. Though uncertainties may crop into the project during the execution phase, these can be easily taken care of when your construction contract is wide enough to accommodate and provide for them without tipping you off the ground.

Get in Touch

If you want to ask any questions regarding construction contracts, we will be pleased to help you. Constructive Solutions, Inc. has several years of experience in executing and managing commercial construction projects across San Francisco and San Jose.

Contact us today to discuss your requirements.

FAQs

How to avoid disputes in construction contract agreements?

The surest way to avoid disputes in construction contracts is by drafting a written document that records the agreement reached between the negotiating parties and their respective terms and conditions. Hiring a professional lawyer to scrutinize the contract is another best practice.

What is the relationship between insurance and construction contracts?

Insurance is a vital contractual requirement that acts as a protection against loss, damage and liability in construction projects. A construction contract typically includes insurance clauses like –

• Builders Risk Insurance
• Contractor General Liability Insurance
• Errors & Omissions Insurance
• Commercial Auto/Truck Insurance
• Workers’ Compensation Insurance
• Contractor License Bonds and other Construction Bonds.

What are liens and waivers for construction contracts?

A construction lien is a legal claim made against a property by a contractor, subcontractor, or supplier who has not been paid for work done on that property. A construction lien waiver is a written agreement signed by a contractor, subcontractor, or supplier stating that they have been paid for their work and are giving up future claims or lien on a property.

Relevant Resources:

• General Contractor Can Be Cited For Subcontractor Violations : U.S. Appeals Court
• Risks Involved In Tenant Improvement: Legal Disputes