Basic Overview of Construction Contracts
In every construction project, a written contract between the owner and contractor is essential for the efficient and accurate completion of contract performance and subsequent resolution of any issues that may arise Accordingly, a well-drafted contract will not only help the project proceed but also provide security for both parties if problems should arise . That is the critical importance of having a skilled construction attorney prepare a legally solid, defendable contract.
But what makes a construction contract effective? For starters, it must be detailed and thorough and include a plan schedule, costs and payment schedule, quality specifics, change order requirements, lien waiver provisions and dispute resolution procedures, to name a few. The lease may also include a liquidated damages clause.
Lump Sum Construction Contracts
Lump sum contracts for construction projects are easy to understand basically because they are simple. If you and the other contracting party both know the specification and scope of work, the cost will be easy to determine. You will be able to obtain a price for all work to be done. Plus, because of its simplicity, lump sum contracting places all of the financial risk on the contractor. Although this may seem unfair, there are reasons why lump sum contracts are fair.
Imagine this example: A client needs to have an overland parking deck. The client and contractor agree that the project will be built with the same materials and using the same methods as it was done before, and the deck will add about 500 cars to the client’s parking lot. The client and contractor might agree on a lump sum contract. In other words, the price will not change regardless of whether it costs ten million dollars or ten dollars. In the past, the structure cost ten million dollars. The contractor and client need to come up with a new number for the new project in order for the contractor to be paid fairly, and for the client to get the product and services he wants and needs.
Assuming the AIA Agreements are used, Article 11.3 explains that "terms of the Contract Documents" will determine the damages which arise from delays, so there is nothing in Article 11.3 of the AIA A201 which precludes the owner or architect modifying the schedule without any contractual risk.
In other words, the contract permits the owner or architect to ensure the project runs smoothly. This allocation of risk is fair, and to be expected in a well-drafted contract. If a contractor believes that these risks continue to be contractually borne by it, in subsequent negotiations the contractor can negotiate for these risks to be borne by the owner instead of the contractor. Regardless of which party bears these legal risks, the project will go forward smoothly.
Using a very simplified example, the contractor might agree to construct an addition for $500. The contract will specify the specification and scope of the work, as well as the unit price for changes to the scope of the work. When the addition is completed, the client only pays $500. If the project takes longer than anticipated, the client and contractor have already agreed that it will not affect the price of the contract.
However, if something unexpected occurs, like the client finding out that she needs a swimming pool and a hot tub in the addition, the contractor and client will have to return to the table and negotiate an appropriate additional price for the changes. The client then pays the contractor for the work.
The contractor has no other financial risk beyond the time when it completes the work. It has no exposure for the increased costs that result from the price of the materials and labor. It also does not benefit from any lower costs by way of reward or incentive of a reduction in the contractors pricing.
For more complex projects, if a contractor offers unqualified prices, it may be said that the contractor has a duty to disclose the full prices coupled with a duty to include them in the agreement.
Disadvantages
While there are many benefits to using a lump sum contract for construction projects, there are some potential disadvantages that clients and contractors should consider.
For example, because a lump sum contract is a set price for a project, if costs rise, clients may be taken to court in order to pay the contractors fairly. The lump sum contract will likely require that evidence be put before the court to show the full cost of the project and the various ways the contractor had to increase the bid, causing additional costs.
In other words, the lump sum contract will still require the owner to litigate the matter.
A lump sum contract works best when the project specifications, design, and materials are determined and documented in detail. Until the owner creates a completely detailed "why" and "how", the contractor is disadvantaged if it agrees to a lump sum contract. The contractor will be required to offer a ballpark figure and hold the owner and architect to the market price for all materials and labor.
If large and small disputes arise between the parties, both may face litigation.
Without an unambiguous, clear, and explicit contract, it is easy for a dispute to arise as to the interpretation of the contract.
Cost-Plus Construction Contracts: How They Work (with Examples)
Cost-plus contracts are most commonly utilized in government industries. With this type of construction contract, the contractor submits a proposal that factors in the approved cost, plus a profit margin that was agreed upon by whoever is hiring them.
How it works
When a cost-plus contract is used, the contractor is rewarded based on their efficiency in spending money. If they are able to save the client money or labor while staying within budget, they are able to keep the underage as profit. However, if they go over the originally contracted amount for any reason, that percentage is then added on to the final bill.
One example
A city is constructing a bridge and the bidding process has been completed. The winning contractor bids a total of $2,000,000 in materials and labor. So long as the contractor is able to keep the project in budget, they are able to keep 10 percent of any money saved. If they aren’t able to, then the final cost will be $2,200,000.
Another example
You’ve won the bid to build a multi-use apartment/retail center. You’ve quoted the job a price of $800,000 in labor and materials and a 15 percent profit margin. After the building project is complete, you’ve only gone over actual spending by $40,000. Your total bill to the owner by the end was $900,000.
Unit Price Contracts in the Construction Industry
A unit price construction contract calls for rates to be provided for work units, whether time units (hours) or quantity units (per square meters to be tilled, tons to be excavated, trees to be cut). The parties agree what work will be included in the contract and the unit rate to be paid for each work unit. If the work ends up taking more work units than anticipated, the Contractor gets paid for the extra work units at the applicable unit rate. The intended use of the unit price contract is to achieve a factor of economic efficiency, by agreeing on unit costs to take advantage of economies of scale. This type of contract is most often used where the project has repetitive features that will be built many times, so that economy of scale will reduce labour and material costs per same delivered piece of work. The unit price contract is normally applied to separate items of work, with a unit price for each item of work, like say: excavate 5,000 cubic meters of rock in an excavation, compact 1,000 square meters of fill, install 3,000 linear meters of curb and gutter quickly and efficiently. There will be in the contract a schedule of unit prices for the work. The unit price schedule will set out the various unit prices for types of work, like concrete finishing, concrete formwork, concrete reinforcing steel, steel erection, etc. The schedule will usually include a separate lump sum price to carry out the prime contractor’s project specific overheads, self perform or lower tier subcontractor cash costs, prime contractor’s margin and profit. The prime contractor’s overheads and costs of performance for the listed unit prices are carried to the lump sum cost of the prime contractor’s project overheads and margin. The variance between the unit price costs and the lump sum cost of the prime contractor’s overheads is intended to be a "tie breaker" so that the overhead costs of prime contractors bidding on a large project with many disparate unit costs can be compared. This "tie breaker" allows the owner to compare and assess the price of each bid based on the common measurement and value of the pre-agreed unit prices, while setting aside the amounts designated for the overheads and margin to fairly assess the contractor’s relative price for performing the various units of work. It also allows for addenda to be issued with changes in scope to include new or revised unit prices without requiring total re-pricing of the work. The dollar amounts to be added to or subtracted from the bid price are the product of the change in unit prices (as per the change order) multiplied by the pro-rata quantities for those unit prices (as per the schedule of quantities). Nobel-prize physicist, physicist, mathematician and cosmologist Albert Einstein said of the unit price construction contract, "can’t we just agree on a fair unit price, so that the cost of the work actually performed can be compared on an apples to apples basis?" Unusual items of work may include a detailed schedule of particular or extra items that have been added and priced by the parties. Actual extra work or change orders may then be compared to the schedule of items. This will help address the problem of quantity of work units that off site conditions cannot be accurately foreseen. Rather than trying to figure out from plans and specs that are not site specific how much excavation of soft clay material is actually going to be required, the parties will agree on a fair and reasonable cost for excavating that material on a separate schedule. If as the project is constructed, the soft clay is discovered, it is then removed and costed to the agreed unit price. If its never found, well then it was just an "extra cost contingency" included in the pricing of the work units. The variation from the agreed unit prices is calculated as per a change order process, based on the actual quantities of work units performed times those unit prices. Alternately, unit prices may be pegged to a published unit price schedule for work units. Such published unit price list is the best practice scenario to administer the unit price contract and assess extras. For example, the Canadian Construction Document Standards (CCDC) has the CCA 8 Owner/Contractor agreements, that are more of a published unit prices list in one document with corresponding general terms and conditions of other contract documents. A solicitation of proposals that adopts CCA 8 as the contract agreement, incorporates the unit prices in the bid proposal (with the overheads and margin in a lump sum at its own line), and the tender or bid form will typically say that the submission will be deemed to constitute an offer to enter into the stated contract, when the contract is awarded. This type of contract will lead to more competitive pricing amongst bidders, because total unit prices per square meter of work can be compared. A wise owner should do their homework and source the price of unit costs (tooling, equipment, labor, logistics, consumables, G&A, indirect overheads, installation and material) for each item of work, in each relevant market. With such information, the owner will be set up to interrogate, analyze, evaluate and test the low bids’ unit prices with the goal to verify or validate their reasonableness. Probabilistic analysis of the owner’s sources of unit prices in the relevant market will more accurately permit the independent estimation of quantities of work units that will be required for the work.
The Basics of Time and Materials Contracts
Time and materials contracts are a unique breed when it comes to contracts that apply to the construction industry. Some disagreement exists about how to classify these contracts, as some might classify them either as a hybrid or unit-price contracts. However, it’s probably most accurate to refer to them as a hybrid, because they are typically a combination of unit-price and cost-plus contracts.
A standard time and materials contract is when a client agrees to pay a contractor based on work done. For example, the client will pay for the cost and labor of materials and for the labor supplied by the contractor. Another example is a contract in which a client pays a flat price for a job, while also requiring the client to pay a pre-agreed upon amount of profits for the contractor, as well as reimbursing the contractor for any materials purchased by the contractor . Similar to a lump-sum contract, the contractor is still required to meet deadlines that were agreed to as part of this contract type.
Some reasons that you might choose to use a time and materials contract are: In terms of actually implementing time and materials contracts, remember that you still have to be careful and draft the contracts appropriately. For example, you should include a provision that sets forth the maximum amount that the contract can total. For example, it should show that work exceeding the budget must be approved in advance by the owner. Even you can take this one step further by stipulating that the materials must be pre-approved by you, adding in a percentage fee to reimburse yourself for your overhead costs, or preventing the use of subcontractors.
How to Include Common Contract Clauses in a Construction Contract
Essential construction contract provisions can vary based on the type of project at issue. However, there are some key contract clauses that should be in any construction contract. Standard form contracts, such as the American Institute of Architects A201-2007 General Conditions of the Contract for Construction, also contain several essential construction contract provisions. The following is a summary of some key contract provisions in the AIA form as an example.
Dispute Resolution
The AIA form of contract recommends that every contract have provisions for alternative dispute resolution (ADR). The advantages of having dispute resolution provisions in construction contracts include: (1) reducing litigation costs; (2) obtaining faster and easier resolution of the dispute (with arbitration being confidential); (3) providing for expert resolution of complex factual issues; (4) potentially avoiding win-lose situation; (5) permitting broader remedies; (6) permitting other types of resolution.
Termination
The AIA form of contract recommends that every contract have provisions for termination. The advantages of having termination provisions in construction contracts include: (1) ability to terminate for convenience; (2) ability to terminate for cause; (3) permit contract to continue under certain conditions; (4) ability to recover lost profits.
Progress Payments
The AIA form of contract recommends that every contract have provisions for progress payments. The advantages of having progress payment provisions in construction contracts include: (1) rewarding timely performance; (2) permitting good cash flow; (3) permitting work to continue without delay; (4) preventing unfair withholding of payments.
Peer Review
Incorporating peer review in construction contracts is advantageous for complex projects since it permits evaluation of design by a competent authority; fosters conflict resolution; improves quality; and reduces cost. The AIA form of contract does not address the issue of peer review.
Bidding Procedures
Incorporating bidding procedures in construction contracts is advantageous for both owner and contractor by making sure that parties are on the same page; and that bids are fair and consistent. The AIA form of contract merely provides that a bidding procedure be included.
Conclusion: Which Type of Construction Contract Do You Need?
Over the course of this article, we have looked at the four essential construction contract types: lump sum, unit price, cost-plus, and guarantee maximum price. Hopefully by now you are well versed in the major pros and cons of each type. To briefly summarize: The lump sum contract is likely the most familiar to our readers. It is simple, straightforward, and clearly defines how much the contractor will be paid. The downside is that it requires clear, accurate drawings and specifications from the owners.
The unit price contract is a variant of the lump sum contract. It is normally used for contracts that require a significant amount of excavation work, and it allows the contractor to pay less (or more) for the work depending on how the unit prices are calculated.
The cost-plus contract is simpler than the other three types. The contractor is simply paid whatever it costs to provide the contracted services. From a financial perspective it has its benefits , but it also encourages contractors to inflate their costs.
The guaranteed maximum price contract protects the owner from the possibility that the price will balloon due to increased costs. Instead of receiving an unlimited amount for the contracted services, the contractor receives only a set maximum price. If the price is higher than the agreed-upon maximum, the contractor and owner normally share the difference.
Each type of construction contract has its benefits and drawbacks. Deciding which type is appropriate for a project depends entirely on the project itself, and what you want to use the contract for. At the end of the day, it is up to you as the owner, or contractor, to determine which type of contract best fits your needs.
As a parting tip, it is always a good idea to have a construction lawyer review any contract before you sign it. This advice is mentioned throughout the blog. Construction contracts are complicated, and drafting them properly requires a great deal of legal knowledge. By having a lawyer review the contract, you can avoid many of the problems that weak contracts cause.