Because no two construction projects are alike, there are many different types of construction contracts out there to satisfy the needs of all parties involved. Knowing which contract suits the project best helps owners, contractors, and suppliers manage risk and ensure the work and payment go as smoothly as possible.
In this article, we take a look at the 5 main types of contracts in construction, and answer the following questions for each one:
- What are the general features of each contract type? What are their benefits & drawbacks?
- Who bears the most risk in each contract?
- What kinds of projects use each contract most commonly?
Table of Contents
The 5 Main Types of Contracts in Construction
Lump Sum Contracts
Lump sum contracts, also known as fixed price contracts, are the most basic type of construction contracts. That’s because they outline one fixed price for all the work done under them. For this reason, lump sum contracts are extremely common in construction. Odds are most contractors have entered into multiple lump sum contracts in the past.
However, as simple as the one price formula seems, lump sum contracts aren’t so cut-and-dry. Here are a few key benefits and drawbacks of lump sum contracts:
Pros of Lump Sum
- Lump sum contracts simplify bidding. Naming a total price rather than submitting multiple bids simplifies the selection process for owners and GCs.
- Finishing under-budget means high profit margins. Because the price for the project is set in stone, finishing under-budget means you pocket the savings.
Cons of Lump Sum
- Miscalculations destroy margins. When drafting a lump sum contract, you need to account for every variable. Since there’s one set price, unexpected setbacks or changes during a project cut directly into your profit margin.
- The bigger the project, the more room for loss. If you’re working with subs and suppliers, there is no room for error. The cost of those inevitable missteps and setbacks from sub-tiers comes right out of the lump sum price.
As you can see, lump sum contracts involve a fair amount of risk for contractors because they don’t account for unexpected costs or delays after the project is started. Missteps mean you make less money, or, even worse, lose money on a project.
That’s why lump sum contracts are best suited for smaller projects with predictable scopes of work.
Time and Materials Contracts
As opposed to lump sum contracts, time and materials (T&M) contracts work best for projects in which the scope of work is not well-defined. Time and materials contracts reimburse contractors for the cost of materials and establish an hourly or daily pay rate.
Here’s an overview of the pros and cons of time and materials contracts:
Pros of T&M
- Time and materials contracts are agile. Since the customer reimburses the contractor for the cost of materials and pays an hourly wage, unexpected delays, roadblocks, and other changes to the scope of work are covered.
- Time and materials contracts allow for simple negotiations. Setting rules for what materials will be covered and what the hourly wage will be is simple with time and materials contracts.
Cons of T&M
- Tracking time and materials is time consuming. Logging each and every material cost on a project is no small task, and failure to provide an accurate number upon completion means lower profit margins. Doing a thorough job here means you spend more time crunching numbers and less time doing the work.
- Efficiency isn’t rewarded. Since time and materials contracts pay by the hour or day, there’s no real incentive to finish a project early. However, it’s common practice to stipulate a bonus for finishing ahead of schedule.
When you consider the unpredictable nature of any given construction project, the owner bears a considerable amount of risk with time and materials contracts. That’s because they’re required to pay the contractor for any unexpected costs, changes, or time overruns that take place over the course of the project, costing them more than they initially planned for.
Cost-plus contracts, otherwise known as cost-reimbursement contracts, involve the owner paying the contractor for the costs incurred during the project plus a set amount of money for profit, which can be determined by a percentage of the total price of the project.
The costs covered by cost-plus contracts can involve direct costs (i.e. direct labor and materials), indirect costs (i.e. office space, travel, and communication expenses), and profit (i.e. the agreed upon fee or markup).
Pros of T&M
- Cost-plus contracts are flexible. Cost-plus contracts allow owners to make design changes along the way, and contractors know they’ll be paid for the extra time or materials those changes incur.
- Miscalculations aren’t devastating. Since cost-plus contracts are flexible by nature, inaccuracies in the initial bid aren’t as detrimental as they are with lump sum contracts.
Cons of T&M
- Justifying some costs can be difficult. Cost-plus contracts require contractors to justify the costs on a given project. Sometimes those costs can be hard to account for, and owners can be resistant to reimbursing indirect costs like administrative expenses and mileage.
- Fronting the cost of materials can put contractors in a bind. Since cost-plus contracts operate through reimbursement, paying more than you expected for materials could mean you’re spread thin for the remainder of the project.
When it comes to cost-plus contracts, the majority of the risk is placed on the owner. That’s because the contractor is paid for all costs incurred during the project, and any unforeseen expenses come out of the owner’s pocket. For that reason, cost-plus contracts are best suited for projects in which a lot of creative flexibility is needed.
Unit Price Contracts
Unit price contracts divide the total work required to complete a project into separate units. They are also known as measurement contracts, measure and pay contracts, or remeasurement contracts. The contractor provides the owner with price estimates for each unit of work, rather than an estimate for the project as a whole.
Unit price contracts are useful for projects in which the work is repetitive, heavily dependent on material costs, and the amount of work needed isn’t clear before the project is started.
Pros of Unit Price
- Unit price contracts simplify invoicing. Unit price contracts allow for increased transparency. Owners can easily understand each cost that goes into the final price of the contract because the price of each unit is predetermined. This helps avoid disputes and arguments when it’s time to pay up.
- If more work is required, the profit margin stays the same. Any extra work that’s needed is simply added on as another pre-priced unit, making it easier to manage change orders and other alterations to the scope of work.
Cons of Unit Price
- Predicting the final value of the contract can be difficult. Usually, the amount of units needed to complete a project isn’t known immediately. This means owners may pay more than they expected.
- Remeasurement can delay payment. Remeasurement, or the owner’s ability to compare the price of each unit with the total cost of the project, can slow down payment. Although transparency is something we should all strive towards, this may be something you want to consider.
When it comes to unit price contracts, the majority of the risk lies with the owner because they must reimburse the cost of unexpected units that are added. However, the transparency they afford is a massive benefit to all parties involved.
Guaranteed maximum price (GMP) contracts establish a cap on the contract price. With this type of construction contract, the property owner won’t exceed the contract price. Any material or labor costs above that price should be covered by the contractor.
Sometimes, another type of construction contract may also include a GMP provision. For example, a cost-plus contract could include a clause that limits total costs to a guaranteed maximum price.
Guaranteed maximum prices are a common feature in construction contracts, and they’re best suited to projects with few unknowns. For example, the construction of a retail chain with plans that have been used over and over.
- GMP contracts make for quicker projects. Having a final contract price accelerates the bidding process, and it makes financing projects easier because lenders know the maximum amount a given project will cost early on.
- GMP contracts incentivize savings. Having a fixed price overhead incentivizes contractors to reduce costs and finish ahead of schedule. Owners usually agree to share cost savings with their contractors.
- GMP contracts place risk on contractors. Unfortunately, GMP contracts force the party doing the work to absorb cost overages in the event the contract price maximum is exceeded.
- GMP contracts can take longer to review and negotiate. In order to protect themselves from exceeding the price cap, contractors may try to increase the maximum price of the contract. When this happens, the negotiation process is elongated and the project takes longer to start.
Since the owner won’t pay for any cost overruns, guaranteed price contracts shift a lot of risk onto contractors. Considering that risk, one thing contractors can do is use a good cost estimating software. Job costing is an important accounting process on any construction project, and having a solid estimate will minimize risk by helping contractors avoid overcharging or undercharging the owner.
At its core, every construction contract is an agreement. You and the hiring party should discuss the project parameters to reach a shared conclusion about the best type of contract to use. Ultimately, a good contract benefits both parties equally.
The American Institute of Architects (AIA) and ConsensusDocs both produce standardized contract documents in a variety of formats, including the contract types here. Working from an existing, professional contract template can give you peace of mind that many other construction parties are using the same terms and provisions.
Read more about AIA contracts
- Pros & Cons of AIA Contract Documents
- AIA A401 Progress Payment Clauses
- AIA A401 Final Payment Clauses
Within every type of construction contract, you’ll still want to watch out for problematic clauses. And review the contract for provisions on retainage and contingency, both of which can affect your ability to get paid in a timely manner.