Construction contract types have a significant impact on how projects are estimated. The type of contract selected for a project defines the relationship between a contractor and customer.
Lump sum contracts, also known as fixed price contracts, include a single price for the entire scope of work. These contracts incentivize contractors to keep costs low to increase their profit margin.
In this type of contract the contractor bills the client for direct costs including labor, materials, and subs plus a percentage to cover overhead and profit. This makes it very difficult to produce a job on time and within budget.
Most contractors use this contract when they don’t have enough estimating experience or systems to produce a fixed price estimate. Owners sometimes enter a cost-plus contract believing that they have enough money to complete the project and often find themselves running out of funds before the job is finished.
In theory this type of contract is good for the contractor because it reduces their risk and separates profit from expenses. However, the fact is that it increases the time needed to manage the job and keep accurate records. It requires additional meetings and much more administration time to prepare the reports for billings, labor, and material. It is also a common cause of disputes between the contractor and the owner when mistakes are made. Having the right system in place can help avoid these issues.
Design-build contracts are a type of integrated project delivery method that is becoming more popular in construction. They allow for design and construction to occur concurrently, allowing projects to be completed more quickly and cost-efficiently. They also provide a single point of accountability, which eliminates the conflicting recommendations of both contractor and architect and reduces the risk of unforeseen costs or schedule delays.
A design-build contract is a form of negotiated purchase agreement that includes design, engineering, and construction for a fixed price. The contract specifies the responsibilities of the owner, engineer, and contractor, and includes clauses related to insurance, warranties, dispute resolution, indemnification, and more.
Although a design-build contract can be used on any project, the process is usually suited to high-performing buildings such as parking garages and housing. It requires a level of preliminary engineering and project definition that allows the designer to prepare detailed plans and specifications suitable for construction. The design-builder should also have sufficient bonding capacity to ensure financial health and the ability to complete work on time and within budget.
Lump Sum Contract
A lump sum contract is a great option when the requested work is well-defined and construction drawings and specifications are completed. It reduces owner risk and helps contractors control profit expectations. However, this type of contract is not suitable where the project scope is unclear and requires extensive pre-construction studies or investigations.
Contractors that use efficient construction practices can reduce their overhead costs and increase their profit margin on a lump sum contract, making it less expensive for the client. However, this type of contract can be inflexible if the scope needs to change.
Contractors may pad their estimates of materials and labor costs to protect themselves from going over budget. This can be due to perceived increases in unit prices for materials, labor wages and inflation rates or the impact of changes in the market or economy at large. This padding can cause the contractor to submit higher bids than they would on cost-plus contracts or time and material contracts. The cost of this insurance is passed onto the client in the form of a larger project price.
In this type of contract, a contractor is paid actual direct job cost plus a fixed fee. It is an alternative to a fixed price contract and provides contractors with incentives to complete the work in a timely manner and under budget. It also allows contractors to protect their profits from the possibility of higher than anticipated project costs.
Using panel data, this study investigates the determinants of contract choice and estimates how households respond to prices under different contract types. In particular, it examines the sensitivity of contract choice to price variations and the extent to which household preferences for contract types depend on previous choice. This research adds to the sparse literature on estimating under uncertainty by considering both household responses to prices and the determinants of their contract choices. It is hoped that the findings of this paper can help guide future research on contracting and pricing in construction. In addition, the results can be used to improve the design of contracts and provide better information to households. In this way, consumers can make more informed and efficient decisions when deciding which construction contract to select for their projects.
Assumption of Risk Contract
For renovation, expansion and repair work, some owners may not require competitive bidding and choose a contract with a single contractor. The selection criteria for this type of pricing arrangement can include familiarity with a contractor, integrity, the owner’s confidence in the contractor and immediate and long-range management objectives. In this type of pricing arrangement, the contract must clearly specify risk and responsibility allocations to avoid ambiguity.
A contract with a guaranteed maximum cost arrangement imposes a penalty on the contractor for overruns and delays. The contractor is responsible for costs below the predetermined maximum, with amounts above the maximum being shared by the owner and the contractor. This type of contract can be defended by using the express or implied assumption of risk defense. The former argues that an injured plaintiff understood the risks of the activity and voluntarily assumed them by participating. The latter argues that a reasonable person would understand an activity’s risks and assume them when engaging in it. These legal arguments usually result in a dispute resolution mechanism involving litigation and judicial adjudication.