In this article, you will read about the different types of contracts in construction management, the advantages and disadvantages of each, and how these contracts affect the cash flow of the contractor.
What are the 4 different types of building construction contracts?
1- Lump Sum Contracts.
2- Unit Price Contracts.
3- Cost-Plus Contracts.
4- Time and Materials Contracts.
1 – Lump Sum Contracts
In a lump sum contract, the engineer or/and contractor agrees to do the specified project for a fixed price. Also called “fixed fee contracts,” these are often used for engineering ventures.
A lump sum or fixed fee contract is appropriate if the scope and schedule of the project are sufficiently defined to allow the consulting engineer to estimate project costs.
Advantages of a Lump Sum Contract
- Lower financial risk to client.
- Higher financial risk to contractor.
- Minimum owner supervision related to the quality and schedule of the work.
- The contractor has a higher incentive to achieve early completion and better performance.
- Contractor selection is relatively easy.
Disadvantages of a Lump Sum Contract
- Changes are difficult and costly. (But they usually are.)
- A mostly completed design is needed prior to bidding.
- The contractor may be inclined to choose the cheapest methods/materials that comply with the specifications.
- Hard to build a relationship with contractors because each project is unique.
- Bidding is expensive and lengthy.
- Contractors sometimes add high contingency for each Schedule of Rate item.
2 – Unit Price Contract
A unit price contract is a type of construction contract based on estimated quantities of items included in the project and their unit prices as initially estimated (rates may be hourly, the rate per unit work volume, etc.). In general, the contractor’s overhead and profit are included in the rate. The final cost of the work depends on the total quantity of items required to carry it out and complete it.
Unit price contracts are appropriate only for a project which involves well-known resources in quantities which are unknown at the time of the agreement, and will be defined when the design and engineering or construction work is finished.
A unit price agreement is one of the best choices for construction or supplier projects where the contract documents can correctly identify the various kinds of items, but not the numbers that are needed.
It is not uncommon to combine a unit price contract with a lump sum contract or other types of agreement for some parts of the project.
Factors that affect unit price contracts:
- Permit and Inspection Costs
Advantages of a Unit Price Contract
- It makes selecting a contractor easy (the person with the cheapest unit price is usually chosen).
- It increases the speed of the project, because the contractor wants to finish as many units of work as soon as possible.
- It allows the client to relate the cost of his project to tangible and measurable results (which are the units of work).
Disadvantages of a Unit Price Contract
- When using hours (or any other unit of measurable time, such as days) for unit pricing, the cost of the construction project may be limitless. That’s why in these types of contracts, there is always a maximum number of units that the vendor can charge the client for, and when this maximum number of units is exceeded, the cost of the unit is reduced. In any case, when hours are used as a pricing unit, clients take all the risk in unit price contracts.
- The quality of the work may suffer. Let’s take painting as an example. The faster the contractor finishes the job, the faster he’ll get paid. That may result in substandard quality, because he just wants to finish applying another square meter of paint as fast as possible. Strict quality standards must be used in order to avoid this issue.
- Misleading bidding. Let’s say two contractors are bidding for a job, and each is using the same pricing units, but one of them is cheaper than the other. Instinctively, the client chooses the cheaper of the two. But the cheaper option may actually be slower or have a lower quality of work, etc.
3 – Cost-Plus Contract
This is a contract agreement wherein the purchaser agrees to pay the cost of all labor and materials, plus an amount for contractor overhead and profit (usually stated as a percentage of the labor and material cost). In construction, a cost-plus contract may be specified as:
- Cost-Plus + Fixed Percentage
- Cost-Plus + Fixed Fee
- Cost-Plus + Fixed Fee With Guaranteed Maximum Price
- Cost-Plus + Fixed Fee + Bonus
- Cost-Plus + Fixed Fee With Guaranteed Maximum Price and Bonus
- Cost-Plus + Fixed Fee With Agreement for Sharing Any Cost Savings
Cost-plus contracts are preferred when the scope of the work is indeterminate or highly uncertain and the kinds of labor, material and equipment needed are also uncertain. Under this arrangement, complete records must be maintained of all time and materials that the contractor spends on the work.
Advantages of Cost-Plus Contracts
- They eliminate risk for the contractor.
- They allow the focus to shift from the overall cost to the quality of work being done.
- They cover all expenses related to the project, so there are no surprises.
Disadvantages of Cost-Plus Contracts
- They may leave the final cost up in the air, since they can’t be predetermined.
- They may lead to a longer timeline for the project.
4 – Time and Materials Contracts
Contracts for time and materials (T&M) are a hybrid of fixed and cost-reimbursing contracts, and are used in cases where there can be no clear scope of work: for example, if the number of hours that the client needs is not clear. In this case, a set professional hourly rate is used (for instance, fees and costs). With this kind of contract, it’s always a good idea to set a ceiling or a price that cannot be exceeded, to prevent being overrun with heavy costs.
What are FIDIC contracts and when should they be used in construction?
In the construction and installation fields, FIDIC contracts constitute agreements used as an international standard. This type of contract was created by the Fédération Internationale des Ingénieurs-Conseils, which was established in 1915 by three European nations (Belgium, France, and Switzerland) and is widely known as FIDIC.
The main objective of different FIDIC forms of contracts was to establish standard contracts for a variety of construction and installation projects, in view of the fact that all around the world, such projects are based on the same primary values (apart from the technical and geographical features).
These internationally standardized contracts have evolved over a century of construction and installation project experience and represent records that take the interests of both sides into consideration in a balanced way.
In 1999, FIDIC published a set of normal construction and installation contracts, based on the specific features of each type of proposal.
EPC and Turnkey Contracts
An EPC contract is a contract comprising Engineering, Procurement, and Construction.
A turnkey contract also comprises Engineering, Procurement, and Construction.
When we look at the definitions, it seems impossible to distinguish between the two concepts, but in fact, they differ as follows:
- In an EPC contract, the employer provides the contractor with fundamental engineering. The contractor then carries out a comprehensive design based on the basic design they received.
- In a turnkey contract, the employer provides only the specifications for the project, and it is the contractor’s responsibility to prepare the project’s basic and detailed design.
- In a turnkey contract, it is the contractor’s duty to construct and commission, start-up and transform the plant for the employer, but another third party may be liable for commissioning and start-up in an EPC contract.