5 Popular Types of Construction Contracts

Table of Contents for Types of Construction Contracts-

1. Introduction
2. Types of Construction Contracts
3. Lump-Sum Contract
4. Unit Rate Contract
5. Time & Material Contract
6. Cost Plus Contract
7. Target Cost Contract
8. How to Choose the Type of Contract for your Project?

1. Introduction

A contract is a legal agreement that binds the parties who have signed the contract. A construction contract is done between the client or owner and contractor or sub-contractor. Both the parties involved in the contract agree to the terms and conditions mentioned in it. In case of violation of the agreed terms and conditions, either party has the right to terminate the contract.

A construction contract has various sections in it. The major sections are general conditions, special conditions, the scope of works, designs and drawings, payment terms, quality assurance, and quality control procedures, liquidated damages, force majeure conditions, claim procedure, communication method, and procedure for amendment in contract, termination of the contract, etc.

2. Types of Construction Contracts-

The type of construction contract chosen for a project is based on the project requirement, scope clarity, details availability at the time of tendering, etc.

The different types of construction contracts allocate the different types of risk to both parties. Some contract types put the owner on the higher risk side, some contracts put the contractor at the higher risk and some contracts balance the risks equally between both parties.

The budget and costing also affect the selection of construction contracts. If the project is to be completed in the assigned budget, the type of contract can be different if no budget constraints were applicable.

The pros and cons of different types of construction contracts will be clarified throughout the article with examples. The major five types of construction contracts are listed below.

3. Lump-Sum Contract

A lump-sum contract is one that involves the fixed payment to the contractor on achieving the agreed milestone. The agreed milestone can be the completion of the work or part completion of work. The fixed amount paid to the contractor is irrespective of the quantum of work done.

In a lump-sum contract, a rough estimate of the work is done at the time of tendering. The owner and the contractor estimate the tentative cost of the project and agree to a fixed amount. The payment milestone(s) is/are decided. The detailed design and drawings are prepared during execution and exact work quantities are determined.

The contractor absorbs the variation in work. Either the work increases or decreases than the original estimate. The risk is more on the contractor side if the initial estimate was lower. However, for major changes, the contractor can ask for a revision in price. Thus, scope clarity is required during the tendering process. The higher the scope clarity, the lesser is the risk.

Pros:

1. The amount to be paid is fixed. Thus, the measurements and record-keeping works are minimized.
2. The tender preparation and bidding process is easier.

Cons:

1. Wrong initial estimates or unclear scope may lead to dispute.
2. Suitable only for small scale projects.

Example: The design and drawings contract can be given in lump sum. Once the initial estimate of the number of drawings required for a project is estimated, the cost can be worked out. With a lump-sum contract, the vendor will provide all the necessary drawings required.

4. Unit Rate Contract

The Unit Rate contract contains the rate for each activity to be done in the project to meet the objectives. This type of contract is a precise method of contracting. To calculate the amount, the unit rate is multiplied by the actual work done.

The unit rate contract is suitable for projects with detailed scope. A detailed work breakdown structure is made on the basis of scope to determine the jobs to be done. A document called the bill of quantities (BOQ) is prepared that contains the quantities and unit rate of each job. The unit rate for each job is calculated based on the material cost, equipment cost, and labor cost.

During execution stage, each job is measured as per actual and paid as per the agreed BOQ.

Pros:

1. The risk is more on the owner’s side considering the work scope. More work means more pay and lesser work means lesser pay.
2. Accurate measurements are done for each job and hence better transparency is achieved.

Cons:

1. Every job is measured for its’ quantity, this may be a time-consuming process for large-scale projects.
2. The increase in material and equipment rates leads to a burden on the contractor.

Example: A unit rate contract to construct a residential building where the number of storeys, finishing specifications, etc. has been clearly defined by the owner, and the owner has resources to verify the bills presented by the contractor.

5. Time and Material Contract

In the time and material contract, the contractor is reimbursed for the material and time. The material cost is decided and paid as per the usage.

The rate for usage of labor, equipment, and other resources is agreed upon by both parties. The rate may be per hour or per day basis depending on the ease of calculation and duration for which the resource is being used.

Pros:

1. The quality of material is assured as it can be changed anytime as the owner is paying for it.
2. The contract is agile in nature. The resources can be mobilised and demobilised based on the requirement.
3. Suitable for projects with ill-defined scope.

Cons:

1. The record-keeping for the usage of each resource increases with the time and scope.
2. Two resources of the same nature with different productivity are paid equally. Hence, the overall productivity is affected.

Example: A contract to provide manpower on a daily/monthly basis. The contractor can also provide tools & tackles like wood cutting machines, welding machines, bar bending machines, concrete batching plants, etc. on daily or monthly rental.

6. Cost Plus Contract

The contract in which the contractor is paid for material and resource as actual and a fixed profit margin. The material cost reimbursed to the contractor contains the actual cost of the material.

The labor charges and equipment charges are also paid as per actual with a fixed profit margin.

The contractor is also paid for indirect costs such as logistics, taxes, material testing charges, manpower accommodation camps, etc.

Pros:

1. The contractor is assured of the profit margin.
2. Wrong initial estimates do not affect the project much.

Cons:

1. The owner is put under all the financial risk.
2. Record-keeping is a hefty task.

7. Target Cost Contract

A target cost contract is a cost-plus contract with an upper limit of payment. The contractor is paid as per the actual with profit margin up to a certain limit. Beyond that limit, the contractor has to bear the additional costs. The owner and contractor mutually decide the upper limit of payment.

The target cost contract provides limited flexibility in terms of rework, specification, quality etc.

Pros:

1. The risk is shared between the owner and the contractor.

Cons:

1. The upgradation in quality or specifications put the burden on contractor.

8. How to choose the types of construction contract?

The selection of the type of contract mainly depends upon the control requirement of the owner and risk allocation. Some contracts put the owner in a powerful position but also prone to the risks of budge and time overrun.

For the projects with loosely defined scope, material and time contracts or cost-plus contracts are well-suited from the owner’s perspective if the budget is not tight.

For the equal allocation of risk and to complete the budget within the strict limits, an owner should choose a target cost contract if the scope is not well-defined.

The lump-sump contracts also offer lesser strain to both parties if the initial estimate of work is correctly done. However, miscalculations can lead to disputes.

If the owner chooses to standardize the jobs and limit the cost of each job, a unit price contract is a good option. However, the detailed scope of work needs to be defined for it.

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