Paving project on a fixed-price contract

Fixed-price contracts are among the simplest of all construction contract forms. They allow contractors freedom and flexibility, and they provide owners with a bit of certainty. The contractor predetermines how much the project will cost, builds in their profit and contingency, and works within the contract’s scope. The owner knows that the project won’t exceed a certain amount. 
A fixed-price contract is a type of agreement with a predetermined value that doesn’t change throughout the project, regardless of the time spent on the job or materials purchased.

How fixed-price contracts work

With a fixed-price contract, the contractor prepares a quote, taking the scope of work into heavy consideration. The contractor presents the owner or GC with the quote. Once they agree on how much a project will cost, they sign a fixed-price contract stating the contractor will perform the work for that amount. Changes in man-hours and materials costs after that point are irrelevant.

This contract format works well for simple projects where the scope is very clear. If the owner is clear on what they want, and the contractor has a detailed set of plans to look at, a fixed-price contract can make a lot of sense. But there are always pros and cons to consider.

Types of Fixed-Price Contracts

The US Government prefers fixed-price contracts for all goods and services. These agreements can minimize the risk and maximize value for taxpayers. With a hard limit set by the contract, the contractor has to control their costs to accomplish the project under budget.

However, to accommodate different scenarios, the Federal Acquisition Regulations (FAR) outline several different types of fixed-price contracts. Having options gives the government agency in charge some leeway to tailor the contract to the situation.

Firm Fixed-Price Contract

Firm fixed-price contracts leave the contractor very little wiggle room. These contracts are not adjustable, and the contractor must complete the project for the awarded price. The contractor accepts 100% of the profit or loss during the project.

Incentive Contracts

Fixed-price incentive contracts use a formula to determine profit. A fixed-price incentive contract uses the final negotiated price and compares it to the target price to adjust the profit on the project. 

Every project has a target cost and a target profit, which add up to the target price. Projects also have an actual cost and an actual price. The actual price is the sum of the actual cost and actual profit.

The formula can be a bit complicated, but it basically means the closer the contractor gets to the target price at the end of the project, the higher the percentage of the target profit they’ll be able to keep.

Fixed-Price Contracts with Economic Price Adjustment

Fixed-price contracts with economic price adjustment afford the contractor with a bit of an insurance policy.

The price can be adjusted up or down according to contract-specific contingencies outside of the contractor’s control. For example, if material costs go through the roof, the contract amount can increase to cover the increased costs.

Price Redetermination Contracts

There are two types of price redetermination contracts; prospective and retrospective. They both have ceiling prices established at the beginning of the project, which is the most the government is willing to pay for the work.

Contracts with prospective redetermination allow for price adjustment at a specified time or times throughout the project’s lifespan. The government only uses these contracts when it’s possible to negotiate a fair deal for the initial stage of a project, but not for the subsequent stages. Generally speaking, the pricing periods are at least 12 months long.

Contracts with retrospective redetermination allow for an adjustment to contract price after the completion of the project. This contract type applies more to research and development contracts than construction.

Firm Fixed-Price Level-of-Effort Contracts

Firm fixed-price level-of-effort contracts require the contractor to provide a specified level of effort (labor) for a specified period. The Government pays a stipulated price for this work.

Level-of-effort contracts aren’t common in construction. Instead, they’re more popular for research and investigation contracts. The end result is typically a report of the findings.

The Pros & Cons of Fixed-Price Contracts

Just like lump sum agreements, fixed-price contracts certainly have their benefits and drawbacks. They can be incredibly lucrative, or they can be the sole reason why a contractor loses their shirt on a project.

Pros of having a fixed-price contract:

  • Easy to understand – One of the benefits of fixed-price contracts is that they are easy to understand. The owner knows exactly how much the project will cost, and the contractor knows how much they can spend. The owner or GC doesn’t have to worry about material costs or mounting hourly costs. The contractor doesn’t need to put together complicated invoices or bills, either. 

This simplicity also helps to avoid potential disagreements. Since everyone understands the scope of the project and the value of the contract, fewer items could cause disputes.

  • Risky, but profitable – While a fixed-price contract can be very lucrative, there is more risk involved than some alternatives. Bidding on these types of contracts requires someone highly skilled at accurate estimating.

If the contractor can finish the project well under bid, they can make off with a tidy profit. But if a contractor’s bid is too low, or the site conditions are different from what they expected, they can quickly end up on the losing end of the stick.

Cons of having a fixed-price contract:

  • Unexpected delays – Some issues aren’t run-of-the-mill. If there’s a material shortage or an issue finding affordable manpower, the overhead cost to complete the job can skyrocket. These issues aren’t the owner’s problem. The contractor has to figure them out within the amount of the contract.
  • Changes are time-consuming – Even a fixed-price contract can be subject to changes. Maybe a material simply isn’t available, or the time-frame to complete the job needs an extension due to unforeseen circumstances. In this case, the proper way to handle a change is to create a change order.

Creating a change order isn’t an overwhelming process, but it’s an extra step that an owner and contractor have to take that other contract formats don’t require. For instance, cost plus or time and materials contracts can be much more fluid and adaptable when changes need to occur.

Scope of Work Changes

When a project proceeds under a standard fixed-price contract, there isn’t much room for the contractor to renegotiate the price. If something like a material shortage, price hike, or labor shortage comes up, the contractor will have to shoulder the problem themselves. You could communicate with the owner and possibly amend the contract, but the owner is under no obligation to do so.

However, if the owner changes the scope of work, you may see a change in the contracted price. If the owner changes the plans, changes materials, or otherwise alters the amount of work required from the contractor, the price can go up or down. 

Don’t take any of these changes at face value, even if the change lessens your required work. Contractors should be sure to get a change order for any shift in the project. Should a payment dispute arise, documentation is the only way to prove you’ve completed the project within the contract’s scope.

Choosing the right contract type

If you are bidding on a federal project, you’ll likely be bound to the type of contract that the public agency chooses. For other projects, choosing the right type of contract depends on a lot of factors.

Not sure where to start? Learn more about the most common types of construction contracts and how they work:

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