Industry Insights

Exploring the Various Types of Construction Contracts: Which One is Right for Your Project

Kristen Frisa
May 21, 2024
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A construction contract is the framework for an entire project. Every interaction between construction stakeholders is written in detail in the contract. For that reason, the type of construction contract used for a project can have a big impact on how progress is measured and how responsibilities are distributed. 

There are a few main construction contract types. This article will detail the characteristics of the different contract types in the construction industry and how to decide which one might be right for any upcoming project. It's important to realize that different types of construction contracts may be used for separate project phases. 

The main types of construction contract

Each type of contract organizes construction payments and responsibilities a little differently. It's important to choose which contract lends itself to a specific project's challenges. 

Lump sum contract / Fixed price contract

As the name suggests, lump sum contracts agree on a total contract value for a project. Lump sum contracts, also referred to as fixed price contracts, work best for projects with a clearly defined scope of work. A good example of a project that would work well with a lump-sum project contract would be installing drywall for a set of rooms in a new building. 

Lump sum contracts are simple and straightforward, but it's important to remember that the contractor has a strong incentive to complete the work as quickly and cheaply as possible to come out ahead on the project. Equally, a lump sum project could be risky for a contractor who has missed or miscalculated elements of the project that wind up additional expenses to build than originally thought.

Cost plus contract / Guaranteed maximum price contract

Cost plus contracts promise to reimburse contractors for all project costs, and also pay a predetermined fee to the contractor that will be their profit. The fee may be calculated as a percentage of total project costs. Project costs will include all labor, materials, permits, and equipment needed to complete the work (direct costs) as well as administrative and overhead costs (indirect costs).

Cost plus contracts usually require the contractor to provide an estimate of the entire contract sum to the owner before the project begins. The owner may also put a limit on the maximum price that will be paid out beyond which construction costs will not be reimbursed, known as the guaranteed maximum price (GMP)

Contractors may prefer cost plus contracts because they present less risk of having to pay project costs out of pocket. However, the property owner doesn't know the total cost of construction until the final invoice comes in. Cost plus contracts require a lot of very careful expense and project progress tracking and record keeping for contractors, who have to justify each invoice with thorough backup documentation.

Time and materials contract

Time and materials (T&M) contracts cover the materials costs that contractors incur during the build, and pay a specific hourly rate for each labor hour spent during construction. Materials costs include shipping and a small markup for contractors, while labor costs include wages and administrative costs and allow for a profit margin. 

T&M contracts mitigate much of the risk that contractors often face, ensuring that their project costs are covered throughout the project and that margins are protected. However, as with cost plus contracts, they require very careful expense tracking and documentation. T&M contracts also often include a "not to exceed" clause in them to help project owners with cost control. 

Because they don't try to pin down an exact estimate, they can be beneficial for projects that don't have a well-defined scope of work

Unit price contracts

A unit price contract can offer flexibility and simplicity to owners and contractors for projects that have clear and repeatable elements, but an undefined scope. A unit price contract outlines the cost for one "unit" of work, and multiplies that cost for the number of units involved in the job. The unit pricing includes materials, labor, and overhead costs.

Unit price contracts are simple to track and bill, but the contractor has to be careful to calculate prices correctly at the time of contracting or they will lose a lot of money over the course of the project. Owners must be careful to watch unit numbers throughout the project, or their costs may run much higher than expected.

Factors to consider when choosing a construction contract

The many different contract types offer project parties the chance to pick the one that works best with the project at hand. Here are some things to consider when choosing which contract may benefit an upcoming project.

Project scope and complexity

Some projects, or project elements, are specific and limited in scope right from the beginning, while others may require more flexibility. All project parties need to decide how much financial risk they can handle at the project's outset. 

Invoice collection process and frequency

Project stakeholders shouldn't underestimate the amount of administrative work that goes into cost tracking and billing at each pay cycle. Contractors who sign on to cost plus or T&M contracts must have meticulous tracking processes in place to ensure they are properly reimbursed for their costs. 

Digital tools like Truss can help simplify invoice collection and payment documentation. Contractors can simply add a Truss link to their digital invoices. Truss links allow for partial progress payments on a single payment link, and all payments associated with each invoice are kept in one place so that both contractors and owners can easily track them throughout the project.

Cash flow management

While contracts for long or prolonged projects often allow for progress payments, how and when those projects will be administered may vary. Contractors should ensure they can cover project costs between payments and maintain a healthy cash flow without having to cover too many costs out of pocket throughout the project timeline. 

Regardless of which payment schedule applies, Truss speeds up payment collection by facilitating electronic transfers. Funds are available instantly to pay vendors or spend on Truss cards as soon as the sender clicks "pay."

Reconciliation process

As each payment is made, contractors need to match up the cash intake with project costs in order to monitor and control the construction budget effectively. The process can take many hours of administrative labor, toggling between construction project management software, and accounting and billing software – all of which is intensified when more information is required for billing as with cost plus and T&M contracts.

Truss simplifies reconciliation by integrating with accounting software. Import bills and invoices into Truss and automate reconciliation, resulting in less administrative costs and fewer data entry errors.

Key terms and clauses in construction contracts

Contractors need to thoroughly read and understand any contract they sign on to. Though contracts often use standardized terms, the terms and conditions they apply to the relationship between owner and general contractor are critical to understand. The following are some terms that frequently appear in construction contracts.

Scope of work

The scope of work refers to the exact type and amount of work a contractor will do on a project. The scope cannot be outlined too clearly – any vague terminology could be misinterpreted, leading to payment discrepancies, disputes, and ultimately construction schedule delays or project failure. The scope of work details the exact work that will be done to consider the project complete.

Payment terms

Payment terms outline the rules for both the owner and the contractor when it comes to payment processing. There may be rules for the contractor about the format or documents required for backup, whether payment applications are required, and the timeline for invoicing. Payment terms detail the expectations for payment approvals and when payment will be issued after the owner receives the invoice. These are all critical details for contractor financial management. Truss simplifies and automates payment processes, ensuring timely and accurate payments to general contractors and subcontractors.

Change order procedures

Change orders can be a huge source of distress for construction projects because they represent an alteration of the original contract agreement. A complete change order process should be outlined in the construction contract, including steps for recognizing a change is necessary, alerting the owner that a change is necessary, the approval process, and when change orders can be invoiced. 

Dispute resolution mechanisms

No matter how well-defined a construction project may be at its outset, there will likely be unexpected elements that crop up during the building phases. Hopefully, carefully defined scope, payment terms, and change order procedures can help deal with those unforeseen circumstances gracefully. When they don't, there need to be procedures outlined in contract documents for how to cope with disputes. 

The contractor and owner will need to decide when to proceed with mediation, negotiation, or litigation. Contractors should never forget the power they wield in the form of mechanics liens, which can go a long way in settling disputes. 

Choosing the right construction contract

The type of construction contract used on each project will depend heavily on the project owner, the type of project or phase, and how well the scope is defined when the project begins. Contractors should fully read and understand all the contract terms outlined for each construction project, as well as the rights, responsibilities, and protections they provide. 

Truss can help simplify the payment process regardless of which contract type applies, by allowing contractors to insert direct payment links into their digital invoices, and by automating reconciliation between accounting and invoicing programs. When payments are sent through Truss, the recipient can access funds as soon as the sender clicks "pay," facilitating healthy cash flow throughout a construction project.

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