A lump sum contract is a widely accepted contracting method in the construction industry because it makes the bidding and selection process relatively easy. Read on for a thorough breakdown of lump sum contracts, including the pros and cons of their use for construction jobs.
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What Is a Lump Sum Contract?
A lump sum contract is the most basic type of contract out there. With a lump sum contract, there’s one price for the entire project. Because these contracts are so simple, lump sum contracts are the most common agreements in the construction industry.
Easy peasy, right? Not exactly.
There are a lot of considerations to take into account when operating under a lump sum contract.
How Do You Determine the Price on a Lump Sum Contract?
Because a lump sum contract features one overall price, the contractor had better get that price right! The sum comes from detailed plans and specifications, and a little bit of trust.
Successfully utilizing a lump sum contract means properly anticipating the project’s schedule, all material and labor costs, as well as knowing how much to build into the price for a profit marting and overhead. What’s more, that contractor had better be sure that the owner won’t be trying to call for changes throughout the life of the project.
Serious consideration must be given before throwing out a price for a lump sum contract.
A contractor is required to submit a total project price instead of bidding on each individual item. For this reason, a lump sum contract is normally used on simple, small projects.
Lump Sum Contracts Aren’t as Simple as They Seem
Construction is an industry of bidders. Whoever comes in with the lowest bid will typically win the job. At the same time, it’s a business. If you bid too low, you won’t make any money.
When dealing with a lump sum contract, this risk can be profound. Under many contract types (like a cost-plus contract or a contract with an escalation clause), the price of the project is flexible. It’s based on variables like the cost of completing the work or a rise in the cost of materials, etc.
With a lump sum contract, the price is based on the bid, and that’s it.
It doesn’t take much imagination to see how this could go sideways. Any unforeseen jump in price, any delay, any little issue that occurs eats directly into the bottom line of the project. Steel goes up in price? Tough luck – the price is set in stone. Weather delays costing cash? Sorry – the contract doesn’t account for that.
Obviously, each contract is written differently, and there may be ways to account for potential issues. But the heart and soul of the lump sum contract is the ability to give one clean price. And anyone reading this knows that construction projects don’t typically operate that way.
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Lump Sum Contracts May Give Rise to Payment Disputes
While we have an entire section of lump sum pros and cons (starting below), we should probably just come out and warn you right off the bat that, on some projects and jobs, lump sum contracts might not be the best choice.
Lump sum contracts may be fine for simple jobs, or more complex jobs where the contractor has done an excellent job of mapping or planning out the project. But, when extreme care isn’t taken, lump sum contracts create fertile grounds for sprouting construction payment disputes.
As we’ll discuss in this article, one of the biggest aspects to a lump sum contract is that they are inflexible. However, construction is inherently complex.
On any given project, there may be a number of completely valid reasons that changes become necessary, costs rise, or delays occur. With a lump sum contract, often, the schedule and budget don’t have any ability to handle these events.
On top of all that, where lump sum agreements are in play, everyone is incentivized to hide their margin on the job. It creates a culture of distrust from the contractor down. There’s little benefit to creating open communication and visibility along the payment chain. However, communication and visibility are the best way to avoid payment disputes in the first place. So the question is worth asking – do lump sum contracts pave the way for payment disputes?
For Contractors: Lump Sum Contract Pros and Cons
At first glance, when looking at the pros and cons from the contractors’ perspective, the lists may seem fairly balanced. However, the potential drawbacks for contractors are serious. Lump sum contracts are notoriously inflexible.
Pro – Cost certainty
I mentioned it above, but it can’t be overstated – being able to give the owner one price for work at the start of the job can be a real asset. It can be a liability too, but I’ll save that for the “Cons” section.
Pro – Avoid awkward conversation on margins
When a lump sum contract is used, the only number that really matters is the price. Meaning, unlike other contract methods (like cost-plus contracting), you don’t have to have an awkward conversation with the customer about your margins.
Pro – Potential windfall if the project runs smoothly, finishes early
This ties into the above. Since the only number that matters is the price – if a contractor can finish the job quickly and under-budget, all of the savings go straight to the contractor’s pocket. As we’ll discuss below, the potential for a high reward comes with a correspondingly high risk.
Pro – Minimal contract administration costs
Again, the simple, singular price makes life easy. All a contractor has to do is keep an eye on the budget. On unit price contracts or cost plus contracts, it takes more time to square away administrative needs.
Con – One miscalculation will destroy the budget
That easy pricing might be more liability than an asset for some contractors. Setbacks, miscalculations, design flaws, defects – all of these are common on construction jobs. Where there’s one, concrete price, any of these obstacles will directly eat into the contractor’s margin on the job. Going back to the owner for more funds is common on lump sum jobs, and going back to the customer for more funds is also one of the main causes of construction payment disputes.
Con – No margin for error (subs and suppliers included)
When there are sub-tiers involved on a job, this “no margin for error” scenario caused by lump sum contracts becomes even more profound. Can you trust that your subcontractors and suppliers will provide flawless work, on schedule? If they can’t, any costs associated with delays or fixing issues will come out of that lump sum price. This, too, is a great cause of construction payment disputes.
Con – No flexibility for changes
When lump sum contracts are used, the price is created based on what the customer wants at the outset of the job. But if you’ve spent any time at all in this industry, you know that customers change their mind all the time. When they ask for changes, they might be willing to pay for the difference. But even if they are – the price of proposed changes will be a point of contention. When a more flexible contracting method is used, change orders can be made much more easily.
Con – Pressure to keep an eye on the bottom line
Since there’s one price with no flexibility, when lump sum contracts are used, contractors have to keep a constant eye on the bottom line. This isn’t particularly unique to lump sum agreements – staying on-budget is important, regardless of the project. However, because there’s a distinct price that can’t be adjusted, the pressure to keep an eye on the bottom line can affect work.
There’s been a lot of budget talk so these articles might be helpful:
For Owners: Lump Sum Contract Pros and Cons
Pro – Cost certainty
For most owners, the intricacies of the project might be mostly irrelevant. They want the finished product, and they want to know what it will cost. Construction is a complex process made up of a number of individual tasks – it can be overwhelming. When one overall price can be given, that can put an owner (or another customer) at ease.
Pro – Insulated from cost increases
Another benefit to having one price is that the customer is protected from the effects of delays, defects, etc. At the end of the day, the customer is responsible for the price. Nothing more, nothing less.
Pro – Hands off management of the project
Some other contracting methods or contract types might require some involvement from an owner. With a lump sum contract, as mentioned above, the owner’s only real responsibility is to pay the bill.
Pro – The contractor will be focused on avoiding delays and cost overruns
Since there’s one price that will be paid for the project, the contractor will be inspired. When a lump sum contract is utilized, they’ll focus on streamlining the job to avoid delays or cost overruns. Every hour they save can be put toward the next job, and every dollar they save goes straight into their pocket. This can be a pro and a con, which we’ll discuss below.
Con – The contractor will be focused on avoiding extra costs
Told you – a pro and a con! When the goal is to finish the job as quickly and cheaply as possible, it incentivizes a contractor to use substandard material and to cut corners. Obviously, honest contractors will do honest work. But lump sum contracts still tempt fate, plus they’re the favorite vehicle of dishonest contractors.
Con – Incentivizes hurrying of the project (could lead to defects)
This may be a little redundant, but it’s still important. Beyond trying to minimize material costs, hurrying through a job could result in oversights and defects. When a project is defective, bringing the contractor back and convincing them to correct the work will be tough if they’ve already been paid and won’t be compensated for the fix.
Con – If the bid is high, the owner won’t benefit from the contractor being under budget
If materials were cheaper than expected, if the job was less complex than anticipated, or if there are some other savings on the job – the benefit all goes to the contractor. When an owner is ok with the lump sum price, then this might not be a “con”. However, other agreements might provide a benefit to both sides.
Con – Contractor incentivized to hide margins from the owner
There’s another drawback to having one lump sum price. It incentivizes the contractor to hide their margins. Owners and other customers aren’t always accepting of the fact that their contractor also has to make a profit and pay for overhead. If they know a contractor’s profit margin, they’ll often want to renegotiate. Thus, it’s in the contractor’s best interest to avoid disclosing what they’re making on a job. This can affect parties all the way down the chain, because if an owner knows all of the subs and suppliers and knows what they’re making on the job, they may question the contractor’s fee. This is one of the leading issues when it comes to the acceptance of informational notices in construction.
Con – Lack of project flexibility
It’s extremely common for an owner or another customer to want changes throughout the life of the project. With cost plus contracts, that’s easy! However, when constrained by a lump sum price, it’s extremely hard to work in changes without affecting the overall price.