5 Key Types of Construction Contracts: Expert Guide for Builders

A construction contract is a vital document that outlines the terms and conditions of a construction project between two parties, typically the owner of the project site and the contractor. 

It serves as a legally binding agreement that delineates the roles and responsibilities of each party, as well as crucial project details such as cost, timelines, and types of materials.

In this article, we’ll cover in-depth the 5 key types of construction contracts, and everything you need to do to mitigate risks when it comes to working within the construction industry.

What Is a Construction Contract?

A construction contract is a legally binding agreement between two primary parties: the project owner and the contractor. This essential document outlines the terms and conditions of the construction project, providing details such as roles and responsibilities, cost, timelines, and types of materials to be utilized.

The project owner refers to the individual or entity commissioning the construction project, while the contractor is responsible for carrying out the work according to the agreed-upon terms. In some cases, the contractor may subcontract parts of the work to specialized subcontractors to ensure that every aspect of the project is completed to the highest standards.

Construction contracts play a crucial role in construction management, as they establish a clear roadmap on how the project is to be executed. This level of clarity helps prevent disputes and misunderstandings, as both parties have a mutual understanding of their obligations. In the event of minor disputes, a well-defined construction contract can help resolve issues quickly and efficiently, thereby minimizing potential delays or additional expenses.

There is a variety of construction contract types to suit different project requirements, such as:

• Lump sum contracts: The contractor agrees to complete the project for a fixed price.

• Time and materials contracts: The owner pays the contractor for the actual cost of labor and materials, plus an agreed-upon markup.

• Unit price contracts: The contractor is paid based on specific unit prices for each item of work.

• Guaranteed maximum price (GMP) contracts: The contractor is paid for the actual costs incurred plus a fee, but the total amount is capped at an agreed-upon maximum.

• Cost-plus contracts: The owner pays the contractor for the actual costs plus a fee, without a maximum cap.

We’ll cover each of these contract types in-depth below.

The choice of contract type depends on various factors like project complexity, budget constraints, and the desired level of control by the owner. Ultimately, the suitability and negotiation of the terms of a construction contract will ensure a smoother construction process, benefiting both the project owner and the contractor.

The Importance of Knowing Which Construction Contract to Use

In the world of construction, having a well-defined and carefully negotiated contract is essential. Construction contracts serve as a legally binding agreement between clients and contractors, outlining the responsibilities, risks, and benefits of each party involved in a project. Selecting the appropriate contract type is crucial for a successful outcome.

By understanding the different types of construction contracts available, clients can make informed decisions based on their specific project requirements. Additionally, contractors can better cater their services to meet client expectations, ensuring a smooth project execution. There are several types of construction contracts, such as stipulated lump sum contracts, unit price contracts, and cost-plus contracts, each with its own set of advantages and disadvantages.

Choosing the right construction contract helps mitigate risks inherent in any project. Construction projects come with varying levels of financial, legal, and technical risks. With an appropriate contract in place, parties can allocate risks to the party best suited to handle them, thus reducing project uncertainties and promoting efficiency.

Establishing a clear contractual framework not only mitigates risks but also provides several benefits. For clients, it ensures that they receive a finished project that meets their expectations on time and within budget. Similarly, for contractors, it ensures fair compensation for their work, reimbursement for any additional expenses, and opportunities for dispute resolution.

Different Types of Construction Contracts: 5 Most Common Contract Types in Construction

1. Cost-Plus Contracts

In a cost-plus contract, the contractor is reimbursed for their construction-related expenses, such as labor, materials, and other direct costs, along with overhead, like insurance, mileage, and a portion of office rent. In addition, a predetermined profit margin is included. This type of contract is often used when it's difficult to accurately estimate project costs and allows the owner greater flexibility in making changes to the project scope.

2. Lump Sum Contracts

Lump sum contracts are also called fixed price or stipulated sum contracts, where a single price is set for all work performed in the project. The contractor has to complete the project scope for that fixed price, incentivizing efficient work. Owners benefit from knowing the costs upfront, while contractors assume more risk, as they have to cover additional expenses should they arise. Preliminary project scope and schedule are essential for accurately estimating the project cost.

3. Unit Price Contracts

In a unit price contract, the total contract price is derived based on the quantity of work and the established unit price for each work product. This contract type works well for projects where the exact quantity of work items is uncertain. Appropriate unit rates need to be set with fair profit margins for both the contractor and the owner. As the project progresses and the actual scope is better understood, unit price contracts allow for adjustments and provide more accurate cost estimates to the owner.

4. Time and Materials Contracts

A time and materials (T&M) contract allows for billing the owner based on actual labor hours and material costs incurred during the project. Contractors charge per hour for their labor, while actual costs for materials and equipment are billed to the owner. This type of contract requires extensive documentation to ensure accurate billing but allows flexibility in adjusting project scope without negotiating a new contract. However, there is a risk that final costs could exceed initial estimates.

5. Guaranteed Maximum Price Contracts

Guaranteed maximum price (GMP) contracts involve setting a not-to-exceed total cost for the project. The contractor is responsible for all costs that exceed the agreed-upon maximum, sharing the risk with the owner. If the project is completed below the maximum price, savings are often shared between the contractor and the owner. GMP contracts encourage the efficient use of resources and cost control while providing the owner with the assurance that project costs will not exceed the specified maximum.

Deciding Which Contract Is Right for Your Job

Choosing the right construction contract for a construction project is crucial, as it defines the scope, cost, quality, risks, and responsibilities of all the parties, including the owner and the contractor. The selection of a suitable contract type ensures that project goals are met, and cost and time overruns are minimized. In this section, we will discuss some popular contract types and their suitability for different projects.

Fixed-Fee Contracts: Also known as lump-sum contracts, fixed-fee contracts involve an agreed-upon price for the entire construction project. This type of contract is a favorable option for owners as it reduces financial risks and ensures budget certainty. Contractors, on the other hand, bear the responsibility for any cost overruns. Fixed-fee contracts are preferred when the scope of work and project requirements are clearly defined, and the construction duration is predictable.

Time and Materials Contracts: In this type of contract, the owner is billed for the actual cost of labor, materials, and equipment used in the construction, plus a markup to cover the contractor's overhead and profit. Time and materials contracts provide flexibility to both parties, allowing adjustments to scope and design throughout the project. These contracts are generally suitable for smaller projects or when the scope is not clearly defined.

Unit Price Contracts: These contracts are based on a fixed price per unit of work (e.g., cubic yard of concrete, linear foot of walls). The owner pays the contractor based on the actual quantity of units completed multiplied by the agreed-upon unit price. Unit price contracts are a good option for projects with a clear unit-based scope, such as road or pipeline construction, where the actual quantity of units may vary during the project.

Guaranteed Maximum Price (GMP) Contracts: In GMP contracts, the contractor is responsible for completing the project within a specified maximum price. If the project's actual costs exceed the guaranteed maximum price, the contractor must cover the additional expenses. GMP contracts provide cost certainty for owners, while incentivizing contractors to keep costs under control. They’re effective for complex projects with uncertain scopes, where budgets need to be managed carefully.

Cost-Plus Contracts: These contracts involve the owner reimbursing the actual costs of construction, materials, and labor to the contractor, plus an additional fee (either a fixed amount or a percentage of the total costs). Cost-plus contracts offer the most flexibility, but they can be risky for owners, as costs may escalate without any upper limit. They are most appropriate for projects with uncertain scopes, where design changes are expected, or when innovative materials or technologies are being implemented.

To decide which contract is suitable for a construction project, owners and contractors need to carefully evaluate the project's scope, time frame, budget, and risk factors. By understanding the various contract types and their corresponding advantages and disadvantages, project stakeholders can make well-informed decisions, resulting in successful project execution and completion.

How to Write a Good Construction Contract: 3 Practical Tips

1. Be Specific

A good construction contract should clearly define the scope of work, including the specific tasks and milestones to be achieved by the parties. This can prevent misunderstandings and ensure all parties have a clear understanding of their responsibilities. In addition, the agreement should cover the timeline for the project, including deadlines and milestones.

Detailing the payment terms is necessary, such as specifying when payments will be made, e.g., at the completion of specific milestones or on a predetermined schedule. The contract should also include the process for handling disputes, such as mediation or arbitration.

2. Detail How to Manage Changes

Change orders are common in construction projects, and a well-written construction contract should detail how these will be handled. The agreement should define the process for requesting, approving, and implementing changes to the project scope, timeline, or budget. This includes specifying the responsibilities of each party in managing change orders and ensuring all parties agree on the revised terms before proceeding.

Rather than risking disputes or miscommunication, the contract should outline the procedures for revising any pre-agreed specifications or plans. This may include details regarding authorization requirements, cost adjustments, and the impact of changes on the project timeline.

3. Establish Communication Guidelines

Effective communication is crucial for the success of any construction project, and the contract should establish a clear communication protocol. This includes defining the primary points of contact, their roles, and the preferred methods of communication, such as email, phone calls, or project management software.

In addition, the agreement should require periodic project updates, specifying the frequency and format of these updates and the responsibilities of each party in providing or receiving this information. By creating and adhering to a well-defined communication process, parties can minimize misunderstandings and work collaboratively to achieve the project's goals.

5 Examples of Construction Contracts

Construction contracts are agreements between clients and contractors that define the scope, terms, and conditions of a construction project. These contracts cover various aspects, including project delivery, schedule, and budget. The following are five examples of construction contracts used in real-world scenarios:

1. Lump Sum or Fixed Price Contracts: This type of contract involves a fixed total price for the entire project. The contractor agrees to complete the project for a specific amount, regardless of the actual costs incurred. Lump sum contracts are ideal when the project scope, materials, and timeline are well-defined.

2. Time and Materials (T&M) Contracts: T&M contracts are used when the project scope is uncertain or subject to change. The client agrees to pay the contractor for the actual labor hours and materials used for the project. This type of contract can provide flexibility for both parties but may require more oversight and monitoring to control costs.

3. Unit Price Contracts: In a unit price contract, the client agrees to pay the contractor a fixed amount per unit of work completed. For example, the payment can be based on the number of square feet constructed or cubic yards of concrete poured. Unit price contracts are suitable for projects where the quantity of work is uncertain or variable.

4. Guaranteed Maximum Price (GMP) Contracts: A GMP contract establishes an overall price ceiling for the project. The contractor is responsible for completing the project within the agreed-upon maximum price. If the project's actual costs exceed the guaranteed maximum, the contractor bears the financial responsibility. GMP contracts are useful when there is a high degree of uncertainty in both scope and costs.

5. Cost-Plus Contracts: In this type of contract, the client agrees to reimburse the contractor for actual costs incurred during the project, plus an additional percentage or fee for profit. Cost-plus contracts provide flexibility when a project's scope or timeline may be indefinite, and they can encourage the contractor to focus on providing quality work.

Each of these contract types serves different purposes and is suited to different real-world scenarios in construction projects. The choice of contract type depends on various factors, including project scope, uncertainty, and client-contractor relationships. It is important to carefully consider each type's advantages and disadvantages to ensure a successful project outcome.

Key Takeaways on Different Types of Contracts in Construction

When dealing with construction projects, it is crucial to understand the various types of construction contracts. 

Knowing the differences between these contracts can help stakeholders make informed decisions and mitigate risks.

By understanding these key points and differences among various construction contracts, stakeholders can choose the most suitable contract type for their specific project. This knowledge ultimately contributes to the successful completion of construction projects.

FAQs

What's Included in a Construction Contract?

A construction contract typically includes the following elements:

• Scope of work: This defines the tasks and responsibilities of each party. It covers details such as project objectives, technical specifications, and types of materials to be used.

• Payment terms: This outlines the agreed-upon payment structure, including milestones and any deposits required.

• Roles and responsibilities: This specifies the responsibilities of each party, including the contractor, owner, and any additional subcontractors involved.

• Timeline: This establishes the project schedule and any deadlines for completion.

• Dispute resolution: The contract may include provisions for resolving disputes if any issues arise during the project.

• Price adjustment mechanisms: This could include escalation clauses that allow for price adjustments in response to changes in market conditions or unforeseen circumstances.

Who Is Involved in Construction Contracts?

There are two primary parties involved in a construction contract:

• Contractor: The contractor is responsible for providing design consultation, material procurement, and construction services as specified in the contract. They may also coordinate and manage any subcontractors necessary to complete the project.

• Owner: The owner is the individual or entity that owns the project site. They are responsible for providing the necessary funds for the project and ensuring that the contractor remains compliant with all contract terms and conditions.

Additionally, subcontractors or other third-party service providers may be included in the contract, depending on the project's complexity and requirements.

What Is an Escalation Clause in a Construction Contract?

An escalation clause is a contract provision that allows for adjustments in the contract's terms, typically in response to fluctuations in cost, labor, or materials. It helps protect both parties from potential financial risks due to factors beyond their control, such as inflation or significant changes in market conditions. An escalation clause usually outlines specific triggers for the price adjustment and a formula for calculating the revised price. With this provision, both the contractor and the owner can better manage their financial exposure and maintain a balanced and equitable contract.

Who Should Write a Construction Contract?

A construction contract should be written by knowledgeable parties involved in the project, such as the owner and the contractor. An attorney or contract specialist with experience in construction law can also be consulted to ensure compliance with relevant laws and regulations. The contract should outline the scope of work, the project schedule, payment terms, and any other pertinent information specific to the project.

What to Avoid when Writing Construction Contracts?

When writing construction contracts, it is important to avoid the following:

• Ambiguity: Use clear language to define the terms, responsibilities, and expectations for all parties.

• Incomplete specifications: Ensure all relevant details are included, such as materials, methods, and timelines.

• Missing critical clauses: Include clauses for dispute resolution, indemnification, and insurance requirements.

• Unbalanced risk allocations: The contract should fairly distribute risks among parties, so one party is not disproportionately burdened.

How Do You Account for Construction Contracts?

Construction contracts are accounted for using either the percentage-of-completion method or the completed contract method. The percentage-of-completion method recognizes revenue and expenses as the project progresses, while the completed contract method recognizes revenue and expenses only after the project is completed. The choice depends on the contract's complexity, duration, and financing arrangements.

What is Cost-Plus in Construction?

A cost-plus construction contract is an agreement where the contractor is paid for the actual costs of the project plus an additional amount, such as a fixed fee or a percentage of the costs, as a profit margin. This type of contract can provide more flexibility for the contractor but may result in higher costs for the owner if not adequately managed.

What is a Stipulated Sum Contract?

A stipulated sum contract, also known as a lump sum contract, is a fixed-price agreement in which the contractor agrees to complete the project for a specified amount. This amount includes labor, materials, and other expenses related to the project. The contractor is responsible for controlling costs and delivering the project within the agreed-upon amount.

What is a Fixed Price Construction Contract?

A fixed price construction contract, similar to a stipulated sum contract, is an agreement in which the contractor agrees to complete the project for a predetermined price. The contractor bears the risk for cost overruns and must ensure the project is delivered on budget. However, savings achieved through efficient management are retained by the contractor as profit.

What is the Most Common Basis of Payment Used in Construction Contracts?

The most common basis of payment in construction contracts is the unit price contract, which defines a fixed price per unit for the work completed. This method allows for flexibility in adjusting quantities and can accommodate changes in the project scope without significant renegotiations.

What are the Two Methods of Revenue Recognition for Construction Contracts?

The two methods of revenue recognition for construction contracts are the percentage-of-completion method and the completed contract method. The percentage-of-completion method recognizes revenue and expenses as work is completed, while the completed contract method records revenue and expenses only once the project is finished.

What are the Two Major Causes of Legal Disputes in Construction Contracts?

The two major causes of legal disputes in construction contracts are:

1. Contractual ambiguity: Disputes may arise when contract terms are unclear or open to interpretation, leading to differing expectations and disagreements among parties.

2. Delays and cost overruns: Disputes can arise due to project delays, cost overruns, and disagreements on responsibility for the additional costs and time extensions.

What are the Different Types of Construction Contracts in California?

Some common types of construction contracts in California include:

• Cost-plus contracts: The contractor is paid for the actual costs plus a predetermined profit margin.

• Lump-sum contracts: The contractor agrees to complete the project for a fixed price.

• Unit price contracts: The contractor is paid based on the quantity of work completed, at a mutually agreed-upon rate per unit.

• Guaranteed maximum price contracts: The contractor agrees to complete the project for a price not exceeding a predetermined amount, while potential savings are often shared between the owner and contractor.

• Construction management agreements: A construction manager works with the owner to oversee the project, often using a combination of contract types for subcontractors.

Each type of construction contract has its benefits and risks, and the choice depends on the project's size, complexity, and the desired level of control by the owner and contractor.