When planning a construction project, choosing the right type of contract is crucial. The contract not only dictates the terms of the project but also impacts the relationship between the client and the contractor, the allocation of risks, and the overall project management strategy. Here, we explore the types of contracts in construction to help you understand which one might suit your project needs.
What Are Fixed Price Contracts?
Fixed price contracts, also known as lump sum contracts, are among the most commonly used types of contracts in construction. In these contracts, the contractor agrees to complete the project for a set price, which covers all labor, materials, and equipment needed to complete the work as per the agreed scope.
For example, imagine a project to construct a building for $40 million. The contractor agrees to this price based on the provided specifications and drawings. As long as there are no changes to the scope or specifications, the price remains fixed. However, there are variations within fixed price contracts:
- Firm Fixed Price Contracts: The contract price remains firm and does not change regardless of any fluctuations in the cost of materials or labor.
- Fixed Price with Economic Price Adjustment: If the cost of materials (e.g., steel) changes beyond a predefined percentage, the contract price can be adjusted accordingly.
- Fixed Price with Incentive Fee: The contractor receives a bonus for completing the project ahead of schedule or under budget. For instance, if the project finishes two months early, the contractor could receive an extra 5% on top of the contract price.
How Do Unit Price Contracts Work?
Unit price contracts, also known as remeasured contracts, set a specific rate for each unit of work, such as square meters of painting or linear meters of piping. This type of contract is best suited for projects where the exact quantities of work are uncertain at the start. The client and contractor agree on the unit rates for various items, and the total cost is determined by multiplying these rates by the actual quantities measured on site.
For example, consider a project to install a ceiling. The contractor and client agree on rates for different ceiling elements like gypsum boards and tiles. If the ceiling covers 500 square meters, the final cost will be calculated by multiplying the agreed unit rate by 500.
What Are Cost Reimbursable Contracts?
Cost reimbursable contracts, also known as cost-plus contracts, involve the client reimbursing the contractor for all legitimate costs incurred during the project. In addition to covering direct costs such as labor and materials, the client also pays a fixed fee or percentage as a profit margin.
For example, in a cost-plus-fixed-fee contract, the contractor might be reimbursed for all costs plus an additional 10% of the total costs as a fee. This type of contract is useful when the project scope is not well-defined or when flexibility is needed.
How Are Target Contracts Different?
Target contracts set a maximum price that cannot be exceeded. The contractor completes the initial planning and design on a cost-reimbursable basis, and then both parties agree on a target price and duration for the construction phase. If the project is completed under budget, the savings are shared between the contractor and the client, providing an economic incentive to minimize costs.
For example, a project with a target price of $50 million must be completed within a set timeline. If the contractor finishes the project for $48 million, the remaining $2 million may be shared between the client and the contractor.
What Is a Time and Material Contract?
Time and material contracts are often used for smaller projects or when the scope is not clearly defined. In these contracts, the client pays the contractor based on the time spent and materials used. This can be beneficial when flexibility is needed, but it also poses a risk of cost overruns if not managed properly.
For example, if a client wants to paint an apartment, they might agree to pay the contractor for labor hours and reimburse them for the cost of paint and other materials. This allows for flexibility but requires close monitoring to prevent excessive costs.
Comparison Table of Types of Contracts
| Contract Type | Description | Best Used When | Risk Level | Flexibility |
| Fixed Price Contract (Lump Sum) | A contract where the total price is agreed upon before the project begins. Best for well-defined scopes. | Scope of work is clear and well-defined. | Low for the client, high for the contractor. | Low – Fixed price and scope. |
| Fixed Price Contract with Economic Adjustment | Similar to Lump Sum, but includes adjustments for significant changes in material costs. | There is a possibility of significant price fluctuations in materials. | Moderate, depending on material price changes. | Moderate – Adjustments for material costs. |
| Fixed Price Contract with Incentive | Includes incentives for completing the project early or under budget. | Motivating the contractor to complete the project early or under budget. | Moderate, with shared risk on timing and costs. | Moderate – Incentives for early completion. |
| Fixed Price Unit Price Contract | Payment based on agreed unit prices for defined work elements. Adjusts according to actual quantities. | Quantities are uncertain, but the unit prices can be fixed. | Moderate, depends on accuracy of quantity estimates. | Moderate – Adjusts to actual quantities. |
| Cost Reimbursable Contract | Client reimburses contractor for actual costs plus a profit margin. Used when the scope is not well-defined. | The project scope is unclear and cannot be defined accurately. | High for the client, as costs are not capped. | High – Adjusts to actual costs and scope changes. |
| Cost Plus Fixed Fee Contract | Client pays actual costs plus a pre-agreed fixed fee as profit. Suitable for projects with uncertain scopes. | The project scope is unclear, but the client wants to control the profit margin. | Moderate for the client, controlled through fixed fees. | Moderate – Controlled through fixed fees. |
| Cost Plus Incentive Fee Contract | Includes a performance-based incentive in addition to cost reimbursement. Encourages efficiency. | To motivate contractors to be efficient while still covering costs. | Moderate to high, depending on performance criteria. | Moderate – Depends on meeting performance targets. |
| Target Contract | Combines Cost Reimbursable for planning/design with a fixed target for execution. | Planning/design needs to be flexible, but cost and time should be capped. | Moderate, requires accurate planning and negotiation. | Moderate – Flexible during planning but fixed during execution. |
| Time and Material Contract | Client pays for time and materials used. Flexible but can be costly if not managed well. | Scope is unclear, and flexibility is required for changes in materials or time. | High for the client, especially if project management is weak. | High – Adjusts to actual time and material use. |
Conclusion
Choosing the right type of contract in construction depends on the project scope, complexity, and risk appetite of both the client and contractor. By understanding these various types of contracts in construction, you can make informed decisions that align with your project needs and goals.
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