In the world of real estate development and the construction industry, there are several types of contracts that define the trajectory of every project. Understanding the different types of construction contracts is important to anticipate how a project will unfold and the responsibilities of each party is required to fulfill to ensure success. Each type of construction contract offers distinct advantages and considerations that can significantly impact the outcome.
Whether you’re hiring home renovation contractors for remodel services or developing a new construction project from the ground up, this article explains the different types of construction contracts that are used in the construction industry.
What are the different types of construction contracts?
Different types of construction contracts exist to address factors including complexity of a project, the owner’s desire to control costs, and the risk tolerance of parties involved. Here are contracts commonly used in the construction industry that provide approaches that manage those considerations:
- Fixed price contracts,
- GMP contracts,
- Cost-plus contracts,
- Time and materials contracts,
- Design-build contracts, and
- Design-bid-build contracts.
Fixed Price Contracts
Fixed price contract, also known as lump sum contracts, is one of the most popular types of construction contracts.
For the owner, the primary advantage of a fixed price contract is cost certainty. With a predetermined and agreed-upon price, the owner can easily budget for the project.
The owner benefits from not being responsible for unexpected increase in labor, materials, and other unforeseen construction problems that may arise. This comes with the drawback of having reduced flexibility for any changes.
These types of construction contracts offers contractors with clear financial expectations. They can accurately estimate costs, allocate resources, and plan the project accordingly. This certainty allows contractors to optimize their operations and potentially increase profitability.
The main downside to contractors is shouldering the risk of cost overruns. Careful planning and accurate cost estimations are necessary to avoid that risk.
Guaranteed Maximum Price
Guaranteed Maximum Price (GMP) contracts provide owners with the benefit of a predetermined maximum cost plus a contractor’s profit for the project, offering cost control and budget certainty.
Although these types of construction contracts appear to be similar to a fixed price contract, they differ since the owners have the advantage of potential cost savings if the final project cost is less than the agreed-upon maximum price.
If the project is completed for less than the GMP, the owner may provide the contractor with the benefit of sharing in the savings. With that type of agreement, owners need to pay close attention to the work to ensure contractors are not cutting corners or buying low quality materials to complete the project under the GMP.
Contractors are at risk for paying for any costs that exceed the GMP. They must accurately estimate and monitor construction costs in addition to efficiently manage the project to avoid delays.
Owners can require the contractor to regularly report the costs of the project to ensure the construction is progressing within the predetermined budget. This allows owners to have better visibility into the project’s financial status.
To avoid disputes related to costs allowed under a GMP contract, contract language should be drafted by an experienced construction attorney so both parties are on the same page.
Cost-Plus Contract
Cost-plus contracts are a type of construction contract where the contractor is reimbursed for the actual costs incurred in carrying out the project, along with a fixed fee or percentage of the total cost.
Although these types of construction contracts are typically used when estimating the cost of the project is difficult, a contractor generally still needs to provide the owner with a good faith estimate of the project cost. The owner has an interest in reviewing invoices and receipts to ensure costs incurred are reasonable.
The advantage for the owner is the ability to closely track expenses, potentially leading to cost savings. However, the downside is that cost plus contracts can present a higher financial risk for the owner if the project costs exceed initial estimates.
For the contractor, the benefit lies in the assurance of being reimbursed for all legitimate costs incurred, including labor, materials, and overhead expenses.
However, the downside is that the contractor may have limited control over profit margins since the fee is typically predetermined. Contractors must carefully manage costs to maintain profitability while delivering the project to the owner’s satisfaction.
Time and Materials Contract
Time and Materials (T&M) construction contracts are based on the actual time worked by laborers and the materials used in the construction process. These types of construction contracts offer the owner flexibility and transparency during the construction process.
T&M and contracts are beneficial for owners as it allows for changes and adjustments to the project scope during construction, accommodating unforeseen circumstances and evolving needs.
The downside includes cost uncertainty. Although owners have more control over costs by imposing limits and guidelines, it requires active owner involvement to manage the costs.
Contractors benefit from T&M contracts by being fairly compensated for the actual work performed and materials used. However, with that comes the administrative burden of efficiently tracking and reporting labor hours, material quantities, and associated expenses.
Regular communication between both parties is crucial to address cost concerns promptly. By maintaining transparency and collaboration, owners and contractors can navigate the challenges of T&M contracts and ensure the project stays on track financially.
Design-Build Contract
A design-build contract is a project delivery method where a single entity is responsible for both the design and construction of a project, streamlining the process and enhancing collaboration.
The Construction Industry Institute conducted a study that found design-build contracts have several benefits for project owners. For owners, the use of the design-build contracts tends to have better performance in cost, schedule, changes, rework, and practice use.
These types of construction contracts also result in faster project delivery, as the design and construction phases overlap. With the design-build team working collaboratively, communication is enhanced, which enables more efficient decision-making and the ability to address issues promptly.
Design-build contracts provide contractors with the opportunity to be involved in the design process from the beginning, allowing for better coordination and seamless integration of construction requirements. Contractors can work closely with designers to optimize construction methods, materials, and cost-effective solutions.
Contractors should be aware that design-build contracts open them up to greater risk and liability, as they assume responsibility for both design and construction. The need for specialized design expertise may require contractors to form partnerships or subcontract design services. Additionally, if the design phase encounters delays or complications, it can impact the construction timeline and increase project risks for the contractor.
Design-Bid-Build Contract
A design-bid-build contract is a traditional project delivery method where the design phase is completed before the project is put out to bid and awarded to a separate contractor for construction. Unlike a design-built contract, these types of construction contracts require the owner to hire an architect separate from the contractor.
First, the owner of a project retains an architect to design the project. Once the architect complete’s their designs, the owner then seeks bids from contractors to build the project. Construction begins after the owner awards a contract to build the project.
With design-bid-build contracts, the cost to build a project will not be known until the bid stage. Although an owner can inform an architect about the construction budget, their ability to estimate costs will not be as accurate as contractors.
Since the contractor is not involved with the design, there is less coordination, which could result in more design conflicts or defects. This is true with large, complex commercial projects. Design issues could result in increased construction costs.
Conclusion
Choosing from the different types of construction contract requires the owner and contractor to identify their expectations regarding costs and responsibilities. The owner and contractor each have a stake in completing the project timely. Some of the contracts provide more collaboration and coordination than others, which can help achieve that goal. Selecting the right contract requires careful consideration of project requirements, risk allocation, and the desired level of control and flexibility of the parties.