Currently valued at $16.5 trillion, construction is one of the largest industries in the world. Every day, governments, individuals, and businesses around the world launch new projects, relying on construction firms to bring their ideas to life.

But to ensure consistent success and protect the interests of all parties across projects, each initiative demands a specific type of construction contract.

Using the wrong one can work against not just the contractor but also the project owner and everyone connected to the arrangement. We're talking about project delays, disputes, cost overruns, and much more.

In this guide, we’ve explained the main types of construction contracts, touching on their pros and cons, where they’re suitable, and how to manage them effectively.

TLDR:

• A construction contract is a document that spells out the scope of a construction project, its payment terms, and other important rules pertaining to the arrangement between a constructor and the project owner.
• There are several types of construction contracts. Major ones include the lump-sum, unit price, Guaranteed Maximum Price (GMP), cost-plus, time and material, design-build, and Integrated Project Delivery (IPD) contracts.
• According to Arcadis, poorly drafted contracts have, for 13 years, remained the number one cause of disputes in construction projects.
• To maintain success across construction projects, proper contract management is critical. This entails drafting in clear language, centralizing your documents, and automating routine processes.

Understanding construction contracts

Source: Clive Rich via LinkedIn

A construction contract is a legally enforceable document that details the scope of a construction arrangement, its payment terms, party obligations, and other parameters necessary for the smooth execution of the project.

Construction projects are notorious for cost overruns, strict regulatory requirements, and scope creep. So, having a contract in place makes sure your interest is protected throughout the project’s lifecycle.

Also read: What is a Contract? Types, Elements, and Use Cases

Types of construction contracts

There are so many categories of construction contracts to choose from, depending on the size and complexity of the project. However, this section will focus on the most common ones in the industry.

#1 Lump-sum contract

A lump sum contract works with a fixed budget. Thus, it's also called a fixed price contract. Here, the contractor is given a lump sum for the entire project. The agreed-upon price will cover the cost of labor and materials associated with the project once accepted.

For such construction contracts, a well-defined scope is mission-critical. The contractor must have a solid understanding of costs to make this type of contract work.

Many contractors like the lump-sum contract because it has the potential for higher profit margins. If they can save costs without harming the quality of the final work, it's a win-win for everyone.

On the flip side, if the actual costs go higher than expected, it can cut into profits and, in extreme cases, result in losses.

Many businesses are also wary of lump-sum contracts as some contractors might want to cut corners to increase their profits.

#2 Time and materials contracts

In this case, the project owner reimburses the contractor for the materials used, alongside a daily or hourly rate for the time spent on the project.

This type of construction contract is best suited for projects where both parties can’t ascertain how much time and resources the project would consume. It keeps things flexible for the contractor as they’re assured that the costs incurred during the project will be covered.

In many cases, time and materials contracts come with a Guaranteed Maximum Price (GMP), which sets a limit for how high the contractor’s charges can go.

#3 Unit price contracts

In unit price contracts, the project is broken into measurable “units,” and a price is attached to each unit. Let’s say your company is contracted to construct a bridge spanning 5 miles. You may propose a unit price contract where you estimate a fixed amount for each mile completed.

When estimating unit prices, the contractor often factors in the labor costs, the cost of materials, and other overhead expenses associated with each unit.

This type of construction contract makes sense in projects that involve repetitive elements and situations where both parties can’t ascertain how long the project will last.

Contractor like such contracts because their pricing is straightforward. However, poor pricing estimates can result in massive losses.

#4 Guaranteed Maximum Price contracts

This type of contract sets a cap for how high the project owner can go with pricing. If the total project cost goes beyond the Guaranteed Maximum Price (GMP), it becomes the contractor’s responsibility. In such cases, the contract must cut into their profits to handle the overrun.

It’s like setting a spending limit for the project owner. No matter what happens during the project, they cannot exceed that threshold.

Before the project begins, the contractor usually presents a detailed cost estimate, called a "schedule of values." In this document, they specify their direct costs (labor, material, and equipment), overhead costs, and contractor fees.

Once the contract gets signed, the contractor becomes a Construction Manager at Risk (CMAR). At this point, they bear the financial risks associated with the entire project.

#5 Cost-plus contracts

A cost-plus contract creates an arrangement where the project owner agrees to pay for all costs associated with the project. This includes the labor costs, funds for materials and equipment, and an additional fee to the contractor for their work.

The contractor's fee can be a fixed price or a small percentage of whatever the cost of completing the project was.

Unlike the lump-sum contract, where the price is fixed upfront, the cost-plus contract takes care of expenses as they come up. This makes it a good option for projects with an unclear scope.

It is also good for project owners because it motivates contractors to go for quality, as they’re not pressured to cut corners to save costs. The downside, however, is the potential for prices to get unreasonably inflated. In many cases, a price cap is integrated into the contract to control spending.

#6 Design-build contracts

Traditionally, project owners work with designers before moving on to developers for implementation. This means two contracts and a longer waiting time.

In design-build, the construction firm takes on the design and implementation of the build, providing the project owner with one contract, fewer touchpoints, and generally shorter wait times.

While this approach is comparatively faster, it gives the project owner lesser control over the project's design as it allows fewer revisions compared to when hiring an independent architect.

Also, because the entire design and construction process goes through one company, the project owner skips the bidding process, potentially missing out on competitive quotes from other companies.

#7 Integrated project delivery contracts

The Integrated Project Delivery (IPD) contract is slightly similar to the design-build contract because it brings the design and building aspects of the project into one contract. But in IPD, the contract often features three independent parties: the builder, the designer, and the project owner.

In an IPD contract, the parties agree on a lump sum (for instance, $50 million + 10% markup) for design and construction. If the project ends with the team spending less than the allocated amount, the designer and the builder share in the savings, further increasing their profit.

However, if they end up spending more than allocated, they might have to cover the extra costs by cutting into their profit.

Source: Erum M. via LinkedIn

Managing construction contracts

Construction projects aren’t cheap. They’re big-ticket investments with tight deadlines and many moving parts. And if there’s one thing that can make or break a project, it’s the quality of your contract management process.

Issues like cost overrun, missed deadlines, underperformance, and legal disputes don’t just happen. They, more often than not, occur as a result of poor contract management.

Also read: Master the Contracting Process: A Step-by-Step Guide

If you must maintain a high success rate with your construction contracts, follow the steps below:

#1 Draft your contracts with clear terms

Source: Michael Palermo via LinkedIn

According to Arcadis, poorly drafted contracts have, for 13 years, remained the number one cause of disputes in construction projects. Errors in documents and failure by either party to understand their contractual obligations point to improper drafting and review processes.

When fleshing out your construction agreement, keep your language simple and avoid excessive use of legalese. Everyone's role, payment terms, the project's scope, and all important considerations must be understood and accepted before the contract hits execution.

“Avoid unnecessary complexity and shoot for short sentences. Always ask yourself if what you wrote down is clear – could a judge or jury understand the section if there was ever litigation?  If not, rework it.  For example, think about this statement, ‘This Agreement will terminate on August 31, 2021.’  Does this mean that it terminates when the day starts? When the day ends? And when does the day end? At the end of the business day, at midnight, and in what time zone? The better sentence is ‘This Agreement will terminate on August 31, 2021, at 11:59 p.m. Central Time.’ Be precise and concise!”

‍‍~ Sterling Miller, CEO, Hilgers Graben‍
Ten Things: Making Contracts Easier to Sign

#2 Automate your review process

Your contract review process helps you spot errors, omissions, and tricky terms that might put you in an uncomfortable situation. But the problem is, the human mind is easily fatigued. And when it happens, we begin to miss important details. It gets worse when we’re reviewing multiple contracts at a spot.

Fortunately, we have technology to do these mundane tasks for us now. A tool like VerifAI has been trained by hundreds of legal experts and knows everything you should look for in your contracts.

All you need to do is plug in your contract and let it scan the document against a playbook. It’ll highlight every area of concern along with explanations for its suggestions.

“I think AI will eventually be a true gift to legal teams by freeing up more time for lawyers to be creative rather than just doing lower-level types of reviews that can be automated.”

~Genevieve Kelly, General Counsel in Residence, Goodwin Procter LLP
Blending Legal Expertise and Business Acumen

Also read: How to Review Different Types of Contracts | + Free Checklist

#3 Set up tracking for change orders and deadlines

Construction projects don't always go in a straight line. Design modifications, material shortages, and inflation can result in adjustments mid-project. Make sure you have a system for tracking these changes so you can easily tell where the budget is going and what's happening with the project in general.

Deadlines are also an important part of construction projects. Make sure you set up automated reminders to stay on top of important dates and make sure everyone delivers their obligations in due time.

Also read: How to Track Contract Obligations

#4 Maintain a central repository for your contract documents

When handling construction projects, having individual documents scattered across emails, desktop folders, or shared drives is the worst way to manage your contracts.

In such a siloed system, tracking obligations and deadlines is incredibly manual, and you’re bound to scramble when there’s a sudden need for a document.

Maintaining a central repository for all your contracts eliminates this struggle. You can easily retrieve documents when needed, implement automation, and track changes efficiently.

Also read: Tips to Store Your Contracts Effectively

Let technology do the heavy lifting

“Leveraging a CLM has been key because it has reduced a lot of friction from handoffs between legal and business. Rather than going back and forth over email, Slack, Word, Zoom, DocuSign, and a whole tech stack, the CLM acts as a single source of truth.”

~Jonathan Franz, Head of Legal, Crunchbase
Navigating Economic Turbulence and Thriving in Chaos

Managing construction contracts is much easier when you outsource routine tasks to technology.

When you're on top of project timelines and aren't spending half of your time doing administrative work, your chances of succeeding with every project are substantially elevated.

SpotDraft is designed with your success in mind, arming you with every functionality you need to seamlessly manage your construction contracts from start to finish.

Ready for a free demo? Click here to send a request.

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