4 Types of Construction Contracts

A construction contract provides a legal binding agreement between the contractee and the contractor for the execution of a job and how compensations will be distributed. There are several types of construction contracts used in the industry, and certain types of construction contracts are preferred by various construction professionals.

Construction contract types are usually defined by how disbursements are going to be made. It also details other project terms like duration, quality, specifications etc. These contract types come in many variations and can be customized to meet the specific needs of the project.

Generally, there are 4 types of construction contracts:

1. Lump sum contract
2. Unit price contract
3. Cost Plus contract
4. Time and material contract

We will explain the differences between the different types of contracts and which you should choose for your projects. For the rest of this blog, the “builder” shall refer to the entity carrying out the construction services and the “owner” shall refer to the entity contracting the builder to carry out construction services.

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1. Lump Sum Contract

A lump-sum contract sets one determined price for all work done for the project. These construction contracts are also called “fixed price” or “stipulated sum” contracts.

Incentives are sometimes built into these contracts to reward the builder if the job is completed ahead of schedule. These agreements can also include penalties, sometimes called “liquidated damages”, for a job that is completed late. Owners typically use lump sum contracts to steer clear of change orders for any additional or otherwise undetermined work.

When signing a lump sum contract, the builder takes on additional risks since the owner is not obligated to pay more than the original price if the project goes out of scope, problems come up or any other changes occur during the project. Some lump sum contracts account for this by including separate allowances that cover unforeseen costs and changes.

If an owner decides to use a lump sum contract on a project, builders can typically charge a higher fee to account for the additional risks they might encounter. Otherwise, any unforeseen costs may impact a builder’s profits or result in a project not being completed as envisioned.

When to Sign a Lump Sum Contract?

Lump sum contracts are suitable for projects with a defined timeline and scope of work at the tender stage, as they are allowed the builder to price the project accurately. If these are not clearly agreed upon, it can be difficult for builders to estimate costs ahead of time and avoid any over-scopes.

2. Unit Price Contract

Unit price contracts typically emphasize the types of tasks being carried out in addition to the materials used on those tasks. This categorized style of pricing makes it easier for owners to evaluate each cost and allows builders to charge for each category more accurately.

This type of construction contract is not typically used for major construction projects and is more often used for smaller jobs like repair or maintenance work. With unit price contracts, it’s easier to adjust prices when the scope of work changes. The owner then agrees to pay the builder for the unit that the builder expends to complete the project.

Normally, a unit price contract has already factored in: 

• Labour costs
• Material cost
• Overhead costs
• Permit and inspection costs
• Profits etc.

When to Sign a Unit Price Contract?

A unit price contract is useful for projects that can be easily split into bundles of work and for which the final scope of work is unclear. Should a project require more work than originally estimated, the builder can add and bill according to pre-priced units, thereby preserving profitability. Unit price contracts are typically used in public works projects. They can also be used to determine costs for only certain portions of a project that can be easily quantified.

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3. Cost Plus Contracts

This type of contract involves payment of the actual costs, purchases, or other expenses generated directly from the construction activity. Cost-plus contracts must contain specific information on certain pre-negotiated amounts (e.g. percentage of the material and labour cost) covering the builder’s overhead and profits. Costs must be detailed and should be classified as direct or indirect costs. There are multiple variations of cost-plus contracts and the most common are:

• Cost Plus Fixed Percentage
• Cost Plus Fixed Fee
• Cost Plus with Guaranteed Maximum Price Contract
• Cost Plus with Guaranteed Maximum Price and Bonus Contract

Cost-plus contracts are used when the scope of work has not been clearly defined and it is the owner’s responsibility to establish some limits on how much the builder will be billing. When some of the above cost-plus variations were used, those terms will serve to protect the owner's interest and avoid being charged for unnecessary changes.

Cost-plus contracts normally require the owner to pay for all project expenses, like the cost of materials, labour, equipment rentals, etc. Additionally, these types of contracts will also include an agreed-upon amount or percentage that covers the builder’s overhead costs and profit that the owner also pays. Depending on the type of cost-plus contract, the owner may end up paying more than anticipated and therefore generally takes on more risk than the builder.

When to Sign a Cost-Plus Contract?

Cost-plus contracts are normally used when the scope of work, materials, labour, and equipment is not clearly defined or difficult to estimate from the beginning. Projects using cost-plus contracts are more likely to be completed as envisioned since builders are not completely limited by cost. However, this contract type is more complex to manage and requires close tracking.

4. Time and Materials Contract

Time and materials contracts define an hourly or daily rate for builders. In addition to paying this rate, owners also agree to pay the materials needed and other related project costs which are noted in the contract as direct, indirect, markup, and overhead costs.

When to Sign a Time and Materials Contract?

Time and materials contracts are also typically used when the scope of work is unclear and carry less risk when used for small projects where owners can better estimate the project’s scope to anticipate the final cost. Price or project duration caps are also common for this contract to mitigate the owner’s risk.

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In conclusion

Understanding the different types of construction contracts helps you to decide which option is right for you and your project. Besides the contract, there are many other factors to consider such as the amount of labour needed, the construction technology available, equipment/machinery needed, etc. Consider implementing value engineering into your next project to help you weigh out the cost and material options for the best value.

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