While a fixed price or point-of-sale billing structure is used mostly across diversified industries, this contract method fails to serve contractors and project owners. The construction industry tends to be a bit more complicated because of its long-term, project-based, and upheaval nature. Every project is unique and comes with its own set of requirements and challenges. For this reason, it’s essential to have streamlined billing methods in place to profitably biding different projects.
A construction contract is a legally binding agreement for both builders and owners that describes how and when payments will be distributed once a project is executed. It also defines other pertinent project information like duration, liability, quality requirements, specifications, and more.
While there are a number of variations that can be made to meet the specific needs of a project, there are certain types of construction contracts preferred by construction professionals, including:
In this blog, we’ll go deeper into each billing option and make clear the pros and cons of each. Read on to understand the different types of construction contracts and billing models and to determine the right fit for your various projects.
Lump-Sum Or Fixed Price Contract
Lump-sum contracts (also referred to as fixed-price contracts) are the most basic types of construction contracts as they involve a total fixed price for all construction-related activities. Sometimes, these contracts can include incentives for early completion, or also have penalties, called liquidated damages for projects, for late termination.
Pros: Lump-sum contracts offer a simplified bidding process by naming one total price instead of submitting multiple bids. As a bonus, contractors can enjoy higher profit margins by finishing under-budget projects because the project price is already set.
Cons: The way construction operation poses unique challenges, including hundreds of types of overhead, change orders, extended periods and the list goes on. Any deviation and unexpected changes cropping up in the agreed workflow can cut directly into profit.
For this reason, fixed-price contracts work best for smaller projects with a clear scope and a defined schedule. Additionally, the bidding process requires experienced contractors to estimate accurately the expenses to complete a specific project.
>> More: Construction billing methods: 10 Strategies to Take Your Accounts Receivable To The Next Level
Cost Plus Contracts
The cost-plus contract is based on the agreement between the owner and the contractors for the actual costs, purchases generated directly from the construction activity, plus a pre-negotiated fee. The fee may either be a fixed fee or calculated as a percentage of costs. There are multiple variations of cost-plus contracts and the most common include:
Cost Plus Fixed Percentage
Cost Plus Fixed Fee
Cost Plus with Guaranteed Maximum Price Contract
Cost Plus with Guaranteed Maximum Price and Bonus Contract
Pros: This billing method offers the most flexibility, allowing owners to make design changes along the way, and contractors to get full payment for any extra time or additional materials without cutting into the profit margin.
Cons: Cost-plus contracts require contractors to classify and justify the costs which can sometimes be difficult to account for. If not, the owners may be reluctant to reimburse for indirect costs like travel mileage, insurance, or administrative expenses.
The cost-plus billing structure can be helpful in a project with a largely undefined scope. And because the risks of a cost-plus contract are generally higher for the owner, more supervision and accuracy in tracking costs will be needed.
Time and Materials Contracts (T&M)
Time and materials price is based on established hourly or daily rates and all additional expenses arise during the construction process. The expenses including direct, indirect, makeup, and overhead should be classified and included in the contract.
Pros: T&M contracts are a good option when the scope of a project has been clearly defined. It seems attractive for contractors when it allows them to set rules for what materials will be covered and provide flexibility to include change orders. A defined pay rate also adds the advantage of full payment for hours worked if the project takes longer than expected.
Cons: T&M is actually a heavy document process because you only get paid for what’s been documented. Failure to track and log the cost of the time and material can cause lower profit margins. Also, you get paid at an established rate by the hour or by the day, there’s no real incentive to finish a project early unless the contract includes a stipulation to pay a bonus for finishing ahead of schedule.
Time and materials contracts are useful for small scopes or when you make are realistic guess on how long it will take to complete the scope.
Unit Pricing Contracts
The unit pricing contracts are another type of contract commonly used by builders and federal agencies. This type of billing method breaks the project into segments instead of pricing a complete job. The number of units of work is set during the bidding process as the owner requests specific quantities and pricing for a pre-determined amount of unitized items.
Pros: By providing unit prices, the billing can be adjusted up or down during scope changes, making it easier for the owner and builder to reach agreements during change orders.
Cons: Because the number of units of work is usually undefined at the beginning of the project, predicting the final value of a contract can be challenging. That leaves room for potential errors and can lead to delayed payments when remeasurement takes place.