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Four Kinds of Construction Contracts and Factors to Consider

On Behalf of | Nov 16, 2021 | Firm News |

No matter how long you have been in the business, the start of new construction is exciting for you and your client. Your client is adding something new to their life, and you get to help them achieve their goals.

When it comes time to write a contract for a construction job, it is crucial to choose the right type of agreement. There are many types of construction contracts and many circumstances to consider. This post will explore four different types of construction contracts and when you may want to use them.

1. What to know about lump-sum contracts:

A lump-sum contract (sometimes called a “fixed price contract” or “stipulated sum contract”) means that when you are bidding on a project, there is one fixed price for the client to consider.

While a lump sum contract can make the bidding process simpler, there are potential problems, such as:

  • Unexpected expenses; and
  • Limited room for error.

When is a lump-sum contract a bad idea?

Other construction contracts have more room for adjustment if part of the project does not go according to plan or if a client requests changes to the project. A lump-sum contract can also make matters complicated for more complex projects.

The bigger a project is, the more likely it is that there will be changes that impact the cost. If you are bidding on a job that will take a long time or has many complex parts, you may want to use a different type of contract.

2. What to know about time and materials contracts:

Some construction projects are ambiguous by design. You go into them knowing that you will need to be flexible so that your client can make changes as the project goes on. One approach in that case might be a time and materials contract.

Very simply, a time and materials contract is exactly what the name suggests, an agreement based on the time spent and the materials used on the project.

In time and materials contracts, the owner reimburses the contractor for materials and makes periodic payment (typically daily or weekly) for labor costs. Time and materials contracts can work well when project specifications are not clearly known when the project starts.

These contracts provide contractors with a daily or weekly rate, and thus a steady income. However, time and materials contracts require additional paperwork compared to lump sum contracts because labor costs must be recorded accurately. An essential part of a time and materials contract is thus accurate tracking. Both parties should discuss the tracking and reporting methods for costs incurred during the project.

Similar to lump-sum contracts, time and materials contracts make negotiation simple since there is only a handful of details to agree on, such as:

  • Hourly rates for work;
  • The markup on supplies and materials; and
  • Limits on the cost of the project.

3. What to know about cost-plus contracts:

A cost-plus contract is based on a reimbursement model. Similar to the time and materials contract, there is a good deal of flexibility during the project to accommodate changes. However, a cost-plus agreement reimburses expenses “plus” a profit percentage rather than set values upfront.

When drafting a cost-plus contract, it is essential to consider different types of costs, such as:

  • Direct costs. These costs could include expenses such as labor and materials to complete the project.
  • Indirect costs. Indirect costs may include office space, travel and other expenses for operating your business.
  • Profit. During the negotiation, you should agree on a percentage of profit for the project.

While profit can feel like an awkward conversation for some, it is a critical element to negotiating a cost-plus contract. Both parties should be clear about the intended profit for the project.

When should I use one?

The challenging part of a cost-plus construction contract is that it operates on reimbursement. Another type of agreement may stagger payments over the course of the project; using a cost-plus contract means you pay for materials upfront and get reimbursed later.

A cost-plus agreement can allow for flexibility, but there can be difficulty justifying some of the contractor’s expenses in some cases. Oversight is crucial. It is essential to outline the types of costs your client will see on the invoices so you do not have a conflict about line items. It is important that there is clear documentation of the contractor’s spending in receipts or invoices.

Before getting started drafting a cost-plus contract, as with all other construction contracts, you need to be clear in your expectations.

4. What to know about unit price contracts:

A unit price contract divides the work into different priced units. The price is thus determined by these units rather than having a fixed sum for the entire project. When you prepare your bid, you estimate the number of each type of unit the project will require.

An agreement based on units required for the job can give you and your client flexibility during the project to accommodate changes or unexpected conditions during completion. If a project grows in scope, you can bill for the additional units and protect your profits.

What expenses go into the unit price calculation?

Obviously, items like materials, labor, and overhead must be considered in calculating the unit price. The cost of subcontractors is also an important item. Additionally, don’t forget to factor in permit and inspection costs and taxes. Of course, the amount of profit is also a vital conversation.

Because the scope of work needs to be itemized properly, unit price agreements may require more work upfront. Once this upfront work is done, however, a unit price agreement can make tracking costs more transparent.

When should I use one?

Unit price agreements work well when the project requires repetitive work, or the amount of work is not definite at the start of the project, and it is easy to split the project into different units. As you continue with the project, there is room to discuss adding more units to accommodate changes or updated information about the project. This type of contract also may allow a project to get underway sooner since it allows for changes along the way.

Unlike other types of agreements, a unit price contract can make invoicing your client simpler, since you negotiate the cost per unit at the beginning of the deal. Also, since your profit margin remains the same, it is easier to accommodate changes without renegotiating the cost.

5. Conclusion

Proper and effective communication is essential for all successful construction projects, which generally begins with the construction contract. A contract is one of the essential components of your construction project.  A contract that is not enforceable or that leaves important issues unaddressed can cause problems for your construction project. To make sure your construction contract will be enforceable and will be right for your needs, it is important to talk to a trained professional about drafting your agreement.