Fixed-price construction contracts are one of the simplest types of construction contracts. They give contractors freedom and flexibility, as well as some certainty to owners. The contractor estimates the project’s cost, accounts for profit and contingencies, and works within the contract’s scope. The owner is certain that the project’s cost will not be surpassed.
What is a fixed-price contract?
The contractor prepares a quote, taking the scope of work into careful consideration. The quote is presented to the owner or general contractor by the contractor.
When they agree on the cost of a project, they sign a fixed-price contract saying that the contractor would perform the work for that amount. Changes in man-hours and material costs after that time are irrelevant.
This contract type works effectively for simple projects with a clear scope.
A fixed-price contract can make a lot of sense if the owner is clear on what they want and the contractor has a detailed set of plans to look at. However, there are always advantages and disadvantages to consider.
What is a Fixed-Price Contract in Construction?
With this type of contract, the seller and buyer will get into the agreement by deciding on the final cost of the service or good and listing it in the contract. Both parties will agree to this and acknowledge it by signing it. The length of time for the set price is also specified in the contract.
This method involves the client or customer paying a fixed price regardless of the amount of materials used or the amount of time spent on the project. It’s common in the construction field, which is a service-based business.
Dynamic pricing has both advantages and disadvantages. This contract states that the client and construction company have agreed to a fixed price fee that will not vary, in contrast to a dynamic pricing approach in which the price can be adjusted based on material costs and time. Hourly billing is one example of dynamic pricing.
When Should a Fixed-Price Building Contract Be Used?
When dealing with a recurring process, a fixed-price contract is frequently used. For example, when the project will be done over and over again to a standard set in advance, a fixed-price contract is advisable. The costs are going to stay relatively the same throughout.
Another advantage of using a fixed-price contract is its simplicity. If you don’t want to deal with an open-ended billing process or changing material costs, a fixed-price contract will make contracting with a customer a lot easier.
Another benefit of using a fixed-price contract is its simplicity. A fixed-price contract will make contracting with a customer much easier if you don’t want to deal with an open-ended billing process or changing material costs.
Scope of Work Changes in the Fixed Fee Construction Contract
When a project is carried out under a standard fixed-price contract, there is little room for the contractor to renegotiate the price. If a material shortage, price hike, or labor shortage occurs, the company shall be responsible for solving the problem. You could talk with the owner and maybe change the contract, but the owner is under no obligation to do so.
However, if the owner changes the scope of work, the contracted price may change. The price can change if the owner changes the plans, changes the materials, or otherwise changes the amount of work required from the contractor.
Don’t take any of these changes at face value, even if they reduce the problems you have to do. Contractors should get a change order for any design changes. If a payment dispute arises, documentation is the only way to show that you completed the project within the scope of the contract.
The Pros & Cons of Fixed-Price Contracts in Construction
Fixed-price contracts, like lump sum agreements, have advantages and disadvantages. They might be massively lucrative or be the primary reason a contractor loses money on a project.
1. They’re easy to understand
Fixed-price contracts have the advantage of being simple to understand. The owner knows exactly how much the project will cost, and the contractor knows how much they can spend. The owner or general contractor does not have to worry about rising material or hourly costs. The contractor is also not needed to create complicated invoices or bills.
This simplicity also helps in avoiding potential disagreements. Fewer things may cause disputes because everyone understands the scope of the project and the value of the contract.
2. Profitable, but Risky
While a fixed-price contract might be very profitable, it carries more risk than other alternatives. Bidding on these types of contracts requires high accuracy in estimating.
If the contractor can finish the project well under budget, he or she can walk away with a tidy profit. However, if a contractor’s bid is too low or the site conditions differ from what they expected, they can soon find themselves on the short end.
Some issues are out of the norm. If there is a shortage of materials or difficulties finding affordable manpower, the overhead cost to complete the job can skyrocket. These are not the owner’s problems. The contractor must figure them out within the contract’s budget.
3. Changes are time-consuming
Even a fixed-price contract is subject to change. Perhaps a material is simply unavailable, or the time frame for completing the job should be prolonged due to unanticipated circumstances. The proper way to handle a change, in this case, is to create a change order.
Creating a change order is not a difficult process, and it is an extra step that an owner and contractor must take. This is not required for other contract types. When changes are required, cost plus or time and materials contracts, for example, can be far more fluid and adaptable.
4. Market prices change
Market prices change, and this can have a positive or negative impact on the project. Supplies may become scarce or expensive. Of course, they can also go lower. Then there’s the risk that comes with starting any project. Contractors can incur high financial losses as a result of bad weather or other external forces.
5. The certainty of costs
The cost certainty related to the fixed-price contract is both a positive and a negative. For starters, the customer is aware of the project’s cost and wants it to stay unchanged. The contractor, on the other hand, is aware of this. This indicates that they are more likely to charge a higher price since they are factoring in risk to a greater extent than they would under a more flexible agreement.
Fixed-price contracts under FAR
For all goods and services, the US government favors fixed-price contracts. These agreements can minimize the risk while increasing value for taxpayers. With a hard limit set by the contract, the contractor must keep costs under control in order to complete the project on budget.
The Federal Acquisition Regulations (FAR) describe several different types of fixed-price contracts to fit different types. Having options allows the government agency in charge to tailor the contract to the situation.
1. Firm Fixed-Price Contracts
Firm fixed-price contracts give the contractor very little leeway. These contracts are not adjustable, and the contractor must complete the project at the agreed-upon sum. During the project, the contractor accepts 100% of the profit or loss.
2. Fixed-Price Incentive Contracts
Profit is calculated using a formula in fixed-price incentive contracts. A fixed-price incentive contract compares the final negotiated price to the target price to adjust the project profit.
Every project has a target cost and profit that add up to the target price. Projects have an actual cost as well as an actual price. The actual price is the total of the actual cost and profit.
The formula is somewhat complicated, but it basically means that the closer the contractor gets to the target price at the end of the project, the higher the percentage of the target profit they will be able to keep.
3. Fixed-Price Contracts with Economic Price Adjustment
Fixed-price contracts with economic price adjustment give the contractor little insurance.
The price can be adjusted up or down based on contract-specific factors beyond the contractor’s control. For example, if material costs skyrocket, the contract amount can be increased to cover the increased costs.
4. Fixed-Ceiling Price Contracts with Price Redetermination
There are 2 types of price redetermination contracts: prospective and retrospective. They both have ceiling prices defined at the beginning of the project, which is the most the government is willing to pay for the work.
Prospective redetermination contracts allow for price adjustments at a specified time or times during the project’s lifespan. The government only uses these contracts when it is possible to negotiate a fair price for the first stage of a project but not for subsequent stages. In general, price intervals are at least 12 months long.
Contracts with retrospective redetermination allow for a price adjustment after the project is completed. This contract type is more commonly used in research and development contracts than in construction contracts.
5. Firm Fixed-Price Level-of-Effort Contracts
Firm fixed-price level-of-effort contracts require the contractor to put in a specific amount of effort (labor) for a certain period of time. The government pays a fixed price fee for this work.
Level-of-effort contracts are uncommon in the construction industry. They are more commonly used for research and investigation contracts. Typically, the end result is a report on the findings.
The Fixed-price Contract and Agility
Fixed-price contracts incentivize the seller to take the chance in the future. When I suggest using agility to deliver on a contract, I start from the assumption that I cannot guarantee the future. I can provide an estimate but not a promise. The inability to guarantee the future is an undeniable fact. This is a prelude to offering a better approach than the Triple Constraint model.
I request scope flexibility but offer to deliver work within a second of the deadline and a penny of the budget. I do this because empirical evidence shows that buyers will change their minds. Rather than paying for it under the old model, we’ll embrace the change.
If a buyer has flexibility in how a contract is offered, I mention:
- Quality is non-negotiable. We will not compromise on this point.
- We don’t spend months on up-front documentation. All we need is enough information to get started. We will develop the plan as the product evolves in response to the needs of the sellers.
- We’ll deliver value after the first Sprint, and then every subsequent Sprint
- The seller is free to request changes at the end of each Sprint when we show the product
- The seller is free to stop development when they have what they want, even if we’re under budget
To summarize, I believe that the fixed-price model can work with an agile approach when the scope is flexible. When there is no scope flexibility, fixed-price contracts are a risk that could jeopardize your company’s and your employees’ livelihoods. Is that really a risk you want to take?
Because of their simplicity and wide use, fixed-price contracts are incredibly useful to the construction industry. Before proceeding with the contract, it is important to analyze the benefits and drawbacks of a fixed-price contract, as well as to clearly define the budget and scope with the contractor.
Fixed-price contracts, when properly implemented, are an effective tool for minimizing problems and simplifying collaboration between the company and the contractor in construction projects.