When you’re running a construction contractor business, you need solid contracts to protect your business and formalize business relationships. They describe the scope of work you must do, fix a price for the job and set a deadline for completing the project.
Your contract protects both you and your client. They can give you confidence that you’ll get paid on time, and it reassures your client that you’ll do the work on time.
There are several types of construction contracts, so it’s important to understand the difference between them and what you’re potentially signing.
This article will help you choose between the different types of construction contracts to fit the project and offers tips on what to include or look for. We’ll cover:
- How to choose between different types of construction contracts
- 4 types of contracts in the construction industry
- Other types of construction contracts
- What to keep in mind when signing a construction contract
How to choose between different types of construction contracts
Before you choose a contract for construction work, consider these issues:
- How detailed is the project scope? Does your client already know exactly what they want done? Are the final stages still vague and undecided? Some contracts are better suited to an uncertain project scope.
- How much risk are you willing to take? Some types of contracts in the construction industry bring more risk. For instance, you could lose money if the costs of materials go up or the project isn’t completed on time.
- What is the size of the project? Some construction projects go on for months or even years, while others only take a few days or week. Different construction contracts are best for different project sizes.
- Do you expect the project to complete on time? Some types of construction contracts include penalties if you don’t finish on time. If you can already see obstacles that might delay your work, you should consider using those contracts.
If you’re just getting started or have a client requesting a specific type of contract you’re less familiar with, it’s best to consult with a legal professional for guidance before signing a legally binding agreement.
4 types of contracts in the construction industry
The following are four common types of construction contracts used in both residential and commercial construction.
1. Fixed price contracts
Fixed-price contracts — also called lump sum contracts — are the simplest type of construction contract. With a fixed-price contract, you’ll bid your total price for doing the work. It’s up to you to examine the project description and drawings, calculate your costs and come up with a final price.
If you use fixed fees, there is little flexibility for the client to change their mind about the work. A fixed-price contract might have incentives for an early finish and penalties for late completion.
Conversely, because you're getting paid a lump sum, clients don't have to pay you more than the original, agreed-upon price if problems arise during the construction process, the project goes out of scope or other changes happen. Some fixed-price contracts include stipulations to account for unforeseen occurrences and costs.
Pros:
- Incentives for early finish mean that you can earn more if you work ahead of schedule
- Simple contract that makes it clear what work you have to do
- Can usually charge a higher fee to account for the additional risk you take on
Cons:
- Not suitable for complicated projects
- If you don’t get your calculations right, you could end up losing money
- You’ll have to pay penalties if you don’t complete the work on time
Choose this contract for: simple projects with a well-defined scope of work.
2. Cost plus construction contract
If you're wondering, "what is a cost plus contract?" we can explain. With this type of contract, the client agrees to pay the project expenses, including labor costs and materials, plus an extra agreed-upon fee which is your profit. Your fee could be set as a fixed amount or a percentage of the final costs.
A cost plus contract makes it much easier for the client to change the work. It's a good choice if you need to start, but your client still needs to decide on all the final details.
Pros:
- You can get started without waiting for the final details
- You won’t lose out if the project costs spiral out of control
- Projects are completed as planned due to the client wanting to control costs
Cons:
- Your client could keep on changing their mind
- More difficult to track and manage project
- There’s no fixed end date, so the entire project might take a lot longer than you expect
Choose this contract for: projects where the scope of work, materials and labor might be difficult to estimate. Also good for projects where you anticipate change orders.
3. Time and material contracts
With time and materials (T&M) contracts, the client agrees to pay your hourly or daily rate until the work is done. They also pay for your materials and other direct expenses. It allows the client to change the scope of work and details of the project as you go along.
Very often, the client will want to put a cap on the project so that they don't end up paying for a project that keeps getting longer or more expensive. With T&M contracts, clients might ask for a fixed maximum price or a final project deadline. It's an excellent residential construction contract because it's best for small jobs.
Pros:
- You don’t need to know the total cost of materials before you start
- Good for smaller projects
Cons:
- If there are no caps, project can go over initial scope
- If the client asks for a fixed maximum price, you’ll need to calculate the possible length of the project very carefully
Choose this contract for: projects where the scope of work is uncertain.
4. Unit price contracts
Government agencies, large construction contractors, and big corporations sometimes use this type of construction contract for non-complex projects. For a unit price contract, the total work is broken down into separate tasks (units), and you’ll make a bid for each unit. Your unit bid is your total price for doing the work for that unit. It includes your expenses for labor and materials, your fee and any other construction costs.
Unit price contracts are best for projects that have repetitive stages or elements. For example, many public works projects, such as paving streets or painting an office building.
This kind of pricing allows clients to evaluate each cost separately and allows general contractors to price more accurately. This type of contract also typically allows the client to add extra units whenever they want.
Pros:
- You don’t have to wait for the client to decide on every detail before you get started
- Easy to adjust if the project’s scope changes
Cons:
- There are no incentives for an early finish
- Not suitable for complex projects with varied tasks and materials
- Unit pricing can vary when different components vary
Choose this contract for: projects with repeatable elements and routine tasks or maintenance.
Other types of construction contracts
The following contracts are also used in the construction industry but may be less common depending on your trade or can be combined with the above main types of construction contracts.
Guaranteed maximum price (GMP) contract
Also called a not-to-exceed price (NTE or NTX) contract, guaranteed maximum price contracts have a hard cap on the project costs. That is, there is a maximum amount a general contractor can bill a client for a project. They are sometimes combined with other contracts, such as cost-plus.
The GMP contract limits how much an owner will have to pay. Typically, contractors will cover any additional expenses, which shrinks their own profit margin. Depending on how the contract is written, it can benefit both parties. For instance, the project owner and builder may split the savings if the GMP isn't reached.
Pros:
- Fixed maximum gives you greater control over managing costs and schedule
- Incentivized earnings through cost savings split sharing
Cons:
- Needs careful review and analysis of expenses; continuous cost tracking
- Risk falls on the contractor instead of the client
- Because you’ve accounted for costs beforehand, there’s less flexibility for change
Choose this contract for: larger, expensive projects with costs that can be estimated accurately and don't have large price fluctuations.
Incentive contract
Incentive construction contracts are usually tied to a financial payment if a milestone or other objective is achieved. Common incentivized goals include task or project delivery by a specific date or delivery at a lower cost.
Incentives can be negotiated and included in other contract types also, with compensation based on lump sum payments or a sliding scale.
Pros:
- A more collaborative process between the client and contractor
- Helps control costs and schedules
Cons:
- Requires more negotiation upfront and setting clear expectations on what meeting objectives look like
- May need to reprioritize or delay other projects, causing scheduling, supply or client issues
What to keep in mind when signing a construction contract
Beyond choosing the right types of construction contract, you also need to consider a few other issues:
- Make sure your insurance is current. Many clients will ask about your insurance, so ensure your general liability insurance is current before applying. Look for customized contractors insurance that understands your business.
- Anticipate issues. Do your best to think about any problems that could come up, and then write them into the contract.
- Include the payment method. Avoid payment disputes and delays by including clear payment terms.
- Have a plan for disputes. Even if it’s a short, small project, include some agreement about who will mediate if you and the client can’t agree or, worse — gets angry.
You’re ready to pick the right type of construction contract. Read it carefully before you sign it and get started on your new construction project.
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