Lump Sum Construction Contracts

A lump sum contract is a construction agreement in which the contractor agrees to complete the project for a predetermined, set price. Under a lump sum agreement, also known as a stipulated-sum, the contractor submits a total project price instead of bidding on each individual item. Because of its simplicity, a lump sum contract is one of the 5 most common types of construction agreements. However, there are a number of factors to consider to ensure you choose the right contract for your project.

When to use a lump sum contract

There are some situations and projects where lump sum contracts can be the best choice for everyone involved. Generally speaking, projects that work best under lump sum contracts have two crucial factors:

  1. They have a clearly defined scope of work
  2. They are relatively straightforward to complete

For instance, a deck builder could do quite well using lump sum contracts. The design and drawings are usually straightforward and remain unchanged throughout the project, which defines the scope. The lumber package is generally purchased all at once, minimizing the effects of fluctuations in materials pricing on the contractor’s bottom line.

On more complicated projects, like commercial building construction or multi-stage renovations, lump sum contracts might not work as well. Because of the complexity of many projects, unplanned changes are common. Differing site conditions can quickly throw a wrench into even the best laid plans. The more moving pieces there are on a project, the less likely a contractor is to choose a lump sum contract.

On federal government projects, many projects operate under a fixed-price contract, which is very similar to a lump sum agreement. The government prefers these contracts, believing that they are the best way to use taxpayer dollars for acquisitions and projects. Under Federal Acquisition Regulations (FAR), there are several options for fixed-price contracts that cover most scenarios.

Lump sum pricing

Because a lump sum contract features one overall price, without consideration of the actual costs, the contractor had better get that price right. The sum comes from comprehensive plans, detailed construction specifications, and a little bit of trust. 

Successfully using 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 margin and overhead costs. 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.

Let’s dig further into the pros and cons so you can better understand why these contracts do or don’t work for a given project.

The Advantages of Lump Sum Contracts

Lump sum contracts can provide benefits for both sides on a construction project. Here are some of the biggest advantages.

Simplicity

Lump sum contracts are the simplest form of construction contract. They’re easy to draw up and easy to understand. The contract documents clearly state the work in question and how much money the contractor expects at the end of the project.

Contractors like lump sum contracts because they provide some autonomy and freedom to complete the job. Owners like lump sum contracts because owners know exactly what the project will cost them at the end. They don’t have to worry about over-inflated man-hours or material markups. The price is what it is.

Profitability

When a contractor uses a lump sum contract at the outset of the project, they build a bit of insurance into the total price. This insurance protects them from expected but unforeseen contingencies.

If the contractor can control their overhead costs and the issues that come about are minor, they get to keep this built-in insurance fund. Considering that profit is already a piece of the overall price, this additional cash is a bonus.

Financing is easier

Other contracts with more fluid pricing can be challenging to secure financing for. With open-ended contracts, lenders become concerned with overinflated man-hours and mounting contingencies.

Generally speaking, owners have an easier time securing financing with a lump sum contract. Lenders appreciate knowing how much a project will cost at completion. They’re more willing to provide funding on these projects since the entire project’s scope is under one contract with a set value.

Paperwork is straightforward

By nature, projects that move forward under a lump sum contract have very few paperwork requirements. Payments tend to go out on a progress schedule, so owners don’t need to concern themselves with material costs and man-hours. This means that contractors don’t need to create painstakingly detailed invoices or complicated pay apps. Payments are easy.

Cash flow is easier to manage

When you have a detailed payment-roadmap ahead of you, it’s easier to budget and manage your cash flow. Lump sum contracts tend to include percentage payments at certain stages in the project, minus any retention. Knowing what the overall cost of the project will be, they know how much to expect and when to expect it. This schedule and percentage make accounts receivables and cash flow much simpler hurdles to clear.

Unlike cost plus or time and materials contracts, initial mobilization costs are less likely to strangle the contractor under a lump sum contract. They’ll have to put less of their own cash out at take-off before the first progress payment comes through.

The Disadvantages of Lump Sum Contracts

As we already mentioned, lump sum contracts aren’t always sunshine and rainbows. Here are some of the main drawbacks.

High contractor risk

When a contractor agrees to a fixed-price contract, they assume all the risk involved with bringing the project to completion. As mentioned earlier, they built a bit of insurance money into the price, but problems can quickly surpass that fund.

When a lump sum project runs over budget, the contractor shoulders any cost overruns. The owner doesn’t pay more if material prices skyrocket. If an issue comes up requiring additional material or labor, the price doesn’t change. All of these extra costs are the contractor’s responsibility.

Potentially more expensive

It’s understood and accepted that contractors often pad the cost when pricing out a lump sum contract. Owners know that the contractor is assuming the risk on the project, so they’re willing to spend a bit extra for the peace of mind. This makes lump sum contracts more expensive than other contract formats.

The owner doesn’t always get their money’s worth, however. Since the contractor has quite a bit of autonomy under this agreement, they can—and should—shop around for the best price on materials. Dishonest contractors may try to substitute inferior materials in order to pad their profits on the project.

Projects can’t be fluid

As stated earlier, both parties involved in a lump sum contract need to be clear on the scope of work. This is the only way for the contractor to provide an accurate bid and complete the project to the agreed-upon specifications. That also means these contracts can’t be fluid.

Changes that occur during the project can be time-consuming and paperwork-laden. A contractor needs to get a change order from the owner for any adjustment to the scope of work. Change orders are the only way to protect the scope from creeping and reshaping the contractor’s bottom line.

Other contract types absorb changes much easier.

Contractors can hide their profits

The paperwork involved in a lump sum contract is far less detailed than most other contract forms. There’s less need for the contractor to supply itemized materials lists or provide subcontractor and supplier quotes to the owner. This lack of itemization allows the contractor to shift costs around and hide their actual profit.

Unbalanced bids are common on lump sum projects. The contractor shifts some of the profit to the markup in materials or labor to hide their actual profit margin from the owner. While a lump sum is a lump sum, this lack of transparency can allow the contractor to boost their price a bit, considering they’ll never have to produce an itemized invoice to prove their costs.

Common disputes with lump sum contracts

Disagreements and misunderstandings happen on most projects. There are a few common dispute types that occur under lump sum contracts.

It’s important to understand that these contracts are not very transparent. The owner is never really sure where the costs lie and how much the contractor is making on the project. Contractors will naturally hide their margins, and that type of secrecy follows down the payment chain. At any point in the chain, this air of distrust can cause disputes.

Scope creep can be a problem as well. Contractors often feel obligated to accept small changes to avoid upsetting the customer and prolonging the payment process. Several of these changes over time can change the face of the entire project. Without change orders for these adjustments, the contractor might find their profit shrinks or that they’re fighting to recover cash for changes without the records to prove they were at the owner’s behest.

Comparing lump sum to other contract types

There are other contracts available that might create a better, more lucrative or creative project for both the owner and the contractor. When a complex project is on the table, or the owner isn’t quite sure what they’re looking for, these might be worth checking into.

Lump sum vs. cost-plus

If you’re embarking on a project without a clear scope of work, you might consider a cost plus contract. Under this format, a contractor receives reimbursement for the cost of the work, plus a fixed fee. These costs include direct costs like materials and labor, as well as indirect costs like administration and mobilization. The contractor’s profit comes as a percentage of those costs, predetermined in the contract.

Compared to lump sum contracts, cost-plus is far more paperwork and administration heavy. Contractors have to document every cost and provide detailed invoices. This level of detail makes the project very transparent but complicates the payment application process.

However, cash flow can also become an issue. In most cases, bankrolling the project’s initial stages falls on the contractor. This can lock up a lot of cash in a hurry.

The benefit of a cost plus contract to a contractor is that they’ll receive reimbursement for any and all costs on the job. Changes don’t affect their profit nearly as much as they do with a lump sum agreement. The project can change and evolve, which can be a great benefit to an owner.

It’s not all roses for owners in a cost plus scheme. This agreement doesn’t encourage a contractor to get the best price on materials. In fact, it’s quite the opposite. Since profit is a percentage of the costs, the more expensive the material, the greater the profit.

There’s also no incentive for early completion of the project. Labor is a direct cost, so the more man-hours on the project, the higher the profit. With a lump sum contract, the contractor benefits from wrapping up early and moving onto the next project.

Lump sum vs. time & materials (T&M)

A time and materials contract is another format that works well when the scope of the project is unclear. Under this contract, the contractor receives reimbursement for the materials as well as a daily or weekly labor rate. This allows time and materials contracts to be very fluid and adaptable—a significant benefit to both the contractor and the owner on complex projects

When comparing both to lump sum contracts, time and materials contracts share many of the same pros and cons as cost plus contracts. There’s very little incentive to wrap up the project quickly, but the contractor knows they’ll receive payment for any changes in materials or scope along the way. However, cash flow in the early stages of the project is still a problem.

Time and materials paperwork is more complicated than lump sum—it must be painstakingly precise to recover all of your costs. Also, dishonest contractors can still inflate the manhour numbers to boost their profit. However, there’s less reason to boost materials costs since there isn’t a percentage tied to them.

Lump sum vs. unit price

When an owner has an overall idea of what they want, but the roadmap to getting there isn’t exactly clear, unit price contracts can work extremely well. Unit price contracts are essentially a series of lump sum contracts throughout the entirety of a project. The project breaks down into stages, and a contractor will provide a fixed price to complete each stage.

Unlike lump sum contracts, unit price contracts deal with changes pretty well. If a major issue arises, the contractor can handle it as an additional unit and provide a price to complete it. This allows the owner to make changes at will and work with the contractor to create a better project.

Also dissimilar to lump sum contracts, these projects rarely have a predetermined number of units. They can quickly become runaway trains with total costs far exceeding what the owner was expecting.

Similar to a fixed-price agreement, unit price contracts are susceptible to unbalanced bidding and front-loading. To boost their cash flow at the beginning of the project, contractors will include costs from later stages in the earlier phases. If the scope of work changes, the owner could be unwittingly paying the contractor for work they won’t be completing.

Lump sum vs. Guaranteed Maximum Price

As the name suggests, a guaranteed maximum price is the most an owner is willing to pay for a project. While a GMP contract can stand on its own, owners can include GMPs in other contract types as well. They can be similar to a lump sum price contract.

GMP projects can be quicker to get off the ground as they’re easier to find funding for. Lenders appreciate knowing the maximum amount of a project early on. There’s also room to negotiate with owners to share the cost savings with contractors, incentivizing efficiency and finishing sooner.

Like lump sum, GMP contracts put a lot of risk on the contractor. Should the project cost exceed the GMP amount, those additional costs will come out of the contractor’s pocket, not the owner’s. Contractors will often try to negotiate the GMP as well, which could slow the process down.

Choosing the right type of contract

For the best chance at a project going off without a hitch, a lump sum contract requires a crystal clear scope of work. The project also needs to be relatively simple, with as few variables as possible. In this scenario, a lump sum contract works incredibly well for the contractor. On the other hand, a hazy or muddy scope of work is a recipe for a payment issue under a lump sum contract.

If you’re sure you’ve done your homework, a lump sum contract could be very equitable and beneficial for both you and the project owner.

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Are Lump Sum Contracts Too Basic for Construction? | Construction Contracts
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A lump sum contract can make life a lot easier for both you and your customer at the start of a construction job, but it can also lead to problems later on.
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levelset
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