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Types of Commercial Construction Contracts

Handshake between partners on a construction project.

What’s the difference and how to know what construction contract is best for your project?

In the construction industry, there are hundreds of different types of construction contracts, each designed for various project sizes and scopes. Eight common types are cost plus, design build (DB), guaranteed maximum price (GMP), incentive, integrated project delivery (IPD), lump sum, time and materials, and unit price. On the surface, they’re very similar. They serve as the agreement, so all project stakeholders are on the same page. They define the basics like the timeline, budget, specifications, and quality. But, what sets them apart comes down to two things: the financial agreement and who owns the risk.

Here’s a look into the basics of the three types of contracts that Ronco Construction uses most often.

Lump Sum Contract

A lump sum contract is as simple as it sounds — a contractor agrees to complete a project for a fixed price. Think of it as a set-it-and-forget-it type approach. It’s a very popular contract type and often used for smaller projects or projects with well-defined scopes of work because it provides a clear understanding of the total cost of the project upfront.

With the lump sum contract, the contractor assumes the risk of any cost overruns meaning if the job costs more than anticipated, it cuts into the contractor’s profit. On the flip side, they also reap the reward of an increase in profit if the project comes in for less than the agreed-upon price. And because changes in construction projects are common even with the best-defined scopes, change orders are submitted as needed. In some cases, you can be proactive and add a percentage to the lump sum contract in anticipation of changes.

Guaranteed Maximum Price Contract

Another straightforward example is a Guaranteed Maximum Price (GMP) construction contract. With this agreement, a contractor establishes a predetermined maximum price for a project. If any costs exceed this limit, the contractor absorbs the cost. Similar to lump sum contracts, GMP projects have well-defined scopes of work. They outline project costs, general conditions, contingency amounts and allowances in detail. With a GMP contract, however, there’s more transparency with the owner regarding the costs of the project.

GMP contracts are common on large-scale projects and in instances where the contractor and owner have an existing relationship. GMP construction contracts can also include special clauses like shared savings and escalations. These can help minimize the impact cost increases have on the profit of the job. Change orders are still possible with a GMP contract when the scope of work changes from the original agreement. For the owner, this contract can provide greater cost certainty and reduce their exposure to unexpected expenses. And the contractor has an incentive to complete the project on time and within the budget.

Cost Plus Contract

As the name suggests, a cost-plus construction contract is two parts — the costs and the plus. The costs are the construction-related expenses like direct costs of labor, materials and supplies along with indirect costs like insurance, permits, etc. The plus is the contractor’s overhead and profit. This can be a dollar amount or a percentage of the total project cost. This type of contract is very common when projects want to start fast but the scope of work is unclear and maybe the estimate isn’t very detailed. There’s also a high-level of trust involved with this kind of project. It’s very common with owners and contractors who have worked together previously.

A hybrid to the cost-plus contract is to pair it with a GMP. It still operates as the costs and the plus, but the GMP provides the owner with protection that costs stay in check. When used together, the contract is typically first awarded as a cost-plus contract to complete the preconstruction phase of the project. This contract approach allows construction to begin, sometimes on a fast-track design. It helps build momentum while finalizing the rest of the project scope.

Finding the Right Fit

So, how do you know which construction contract is best? Well, it depends. If the project is cut and dry, then a lump sum might be a perfect fit. Or if the project is still in the early stages but has a solid project team on board and clear vision, then a cost plus with a GMP could be the way to go. Ultimately, it comes down to understanding the project details, the timeline and the level of involvement of the owner and project team.

Construction projects are complex, from the work to the contract, and there’s not a one-size-fits-all approach. But there are some best practices to ensure all stakeholders have a good experience. It’s important to clearly outline expectations, establish communication processes, be specific, and define the change order process. Don’t forget to set up contingencies because changes are inevitable. From there, you can find a contract that matches your project’s wants and needs.   

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