The 5 Types of Construction Contracts You Need to Know to Save You Money
Don't sign on the dotted line until you understand the differences.
Construction contracts, what are they and why are they important?
Well, to put it bluntly, they protect you should a disagreement occur. They do this by clearly outlining the scope of work (what is included and not included), contractor responsibilities, client responsibilities, agreement of payment & how payment will occur, how issues will be handled, warranties, holdbacks etc. Basically the holy bible for your construction project.
They're pretty crucial to a project's success, which is why it is not only important to start a new build or renovation (small or big) with a contract but to clearly understand the different contract types available to you.
I always recommend going with a professional designated contract. In Canada, we use the CCDC contracts: https://www.ccdc.org/documents/. If you choose to use a contract that you draft yourself, or that the contractor has drafted, be sure to have it reviewed by a lawyer to ensure the necessary clauses and terms are included that clearly illustrate responsibility and fault. It's important to be sure the contract can be upheld in court.
Without further ado, let's dive into the 5 main construction contract types to choose from, and the pros and cons of each.
Stipulated Price or Lump-Sum
Also known as fixed-priced contracts. These are the most basic type of construction contracts available. Stipulated price or lump-sum contracts outline a firm and fixed price for the scope of work (a detailed list of all the work that is to be completed -- the why's, how's and want's of it all) as detailed in the provided documents.
This type of contract is best used when detailed documents are provided that clearly outline not only what work needs to be completed, but how that work is going to be executed, what it is going to look like in the end, exactly what finishes are to be used, what standards need to be met and how it all needs to come together in the end.
You know what your end cost is going to be and can plan accordingly. If you need financing or a loan to complete the project, this type of contract more easily facilitates bank negotiations.
If the documents were not detailed enough or there are gaps in what you want done vs. what is known on site, the fixed price can be increased through change orders for items that were missed and needed to complete the work. Change orders are typically charged at a premium price with a larger contractor % markup on materials and labour to what would have been charged as part of the original contract value.
Time and Materials
This type of contract is ever changing and the final budget value moves based on how long the work takes to complete and the cost of materials used.
In order for this type of contract to work, the contractor needs to keep a detailed record of hours worked as well as all receipts for materials required/ used, and submit both alongside any invoices to validate the final budget amount and requests for payment.
For small jobs, this is not a bad way to go, so long as the risk is low and the project is able to progress rather quickly. You pay only for the hours worked at the agreed upon labour rate and the cost of materials so there is no markup. You are able to set simple and defined parameters on what the hourly wage will be and what type of materials will be covered as well as what type of documentation is needed for payment to occur.
Is a high-risk type of contract because you pay a fixed hourly rate and a fixed overtime rate. So if the project hours extend beyond expected due to issues or scope increases, you are paying for all those additional needs at an unknown cost until completed. As well, material costs fluctuate greatly in certain situations and in a T&M contract, those fluctuations are passed on directly to you.
The client (you) pays the contractor for the costs incurred during the project plus a set amount of money that is predetermined for profit.
This can be either a fixed agreed upon amount or a % of the total price of the project once complete. This type of contract starts as a time and materials and adds the profit portion to the equation.
The main difference between the two, and the reason to choose a cost-plus, over a time and materials, is that the hourly wage + time for completion are generally lower because there is already an agreed upon profit at completion; the contractor doesn't need to try and acquire that profit by charging a higher rate or extending the duration.
Is a flexible contract type that easily allows for changes to be made to the scope without a large mark up because the contractor knows they will be properly compensated at the end. This contract type is a good option when documentation is not as robust, scope is a little vague, or site conditions are unknown, so rather than paying a large mark up on question marks (which happens in lump sum), you pay for the costs once the scope and impact is understood. For example, opening up the walls to find out if it is load bearing and what that means for next steps.
Includes direct costs of your project and indirect costs like office space, travel, communication, printing etc. In this way it is similar to a lump sum project where administration style costs for proper management and coordination of the project is billed back to the client.
Stipulated Price + Incentive
Starts the same, and operates the same as a stipulated price or lump sum contract except with the added bonus of an incentive to the contractor for either finishing by a particular date or within a defined budget threshold.
This bonus is generally a pre-agreed upon fixed lump sum or a % of the final construction costs. When preparing your budget, be sure to account for the incentive value as part of the final budget costs.
The promise of a monetary incentive at the beginning of a project generally provides better service, dedication, and commitment to meet the targeted end goal. As well, terms are defined ahead of time and cannot be renegotiated, so if it looks like the contractor isn't going to be able to meet the targets that get him the incentive, he can't just change the terms in his favour.
If the contractor performs within the contract terms that you agreed upon at the beginning of the project, you legally must pay him the agreed upon incentive value. The typical range is 10-15% of the final budget costs. So, if your final construction value is $250K and the terms were to complete by a given date, and these terms were met, then you would have to pay up to an additional $37,500 as an incentive for performing.
And if the incentive was finish by a date, not a budget figure, and changes or additional costs arose during construction, those changes become part of the final budget amount. So, it is difficult to plan for the final incentive amount which could drastically swing, and mean you are very over budget by the end and left trying to figure out financing.
Guaranteed Maximum Price
Guaranteed maximum price (GMP) contracts have a maximum cap on the contract price.
With this contract type, you will not pay more than that capped value, regardless if costs continue to incur. Any additional costs are borne by the contractor. This type of contract is sometimes added as a feature to other contract types like T&M or cost-plus contracts to limit the maximum upset value of the construction budget.
The risk to the client is very minimal as the cap has been established, so regardless of site conditions and unknowns, additional costs incurred that extend above the capped value are not passed down to the client.
Due to the nature of the contract, where potential costs cannot be charged back to the client, contractors are pretty hesitant to agree to this type of contract on its own. For it to be considered, VERY detailed drawings and specifications are needed that clearly outline all requirements and scope. Generally, GMP contracts are added to create greater certainty and comfort for other contract types, not as stand alone contracts.
As you can see, there are a few considerations for each contract type, so how do you know which one is best for you?
In my experience, with smaller project scopes, contractors are only comfortable with a Time and Materials style contract because they don't want to be left footing the bill. If this were presented, I would negotiate a GMP add on to that contract type that states the max upset that can be charged --- I've been left footing a bill that was widely over budget in this type of contract wayyyyyy too many times.
If you need the project to be done by a certain date --- say a special holiday or before you go on vacation, go with a Stipulated Price + Incentive, but know that the "urgency" you are placing on the project is a silent agreement to do whatever is needed to hit that target. Aka additional crew members, working evenings, working weekends etc. And if the project wasn't priced with these conditions, it would be considered an extra and be charged back.
My preferred contract type is a stipulated price or lump sum contract. But that is because with my experience and knowledge, I prepare very detailed drawings and information packages for pricing, so there are less risks and unknowns so the project can be more accurately priced upfront. If preparing such a package is not an option for you, or not something you want to undertake, than go with a cost plus model.