Types of Construction Contracts Discretionary Procurement Systems

Mohammed Elaida MCIOB

The construction industry uses different types of agreements conditional on the project’s scope, delivery schedule, budget, and the stakeholders involved. There is no one-size-fits-all construction contract, and there isn’t a perfect contract for any situation. That said, there are procedures which can be followed to choose a contract type that is likely to match a project and the employer’s needs.

Understanding the risks and benefits of each contract type can help the Employer make the best choice for the project. Ultimately, selecting the right contract for a project is an important part of construction financial management, since contracts directly affect expenses, revenue, and profit

1.Lump Sum Contract

Under a lump sum contract, a single ‘lump sum’ price for all the works is agreed upon before the works commence.

This is generally suitable where the project is well defined, when tenders are sought, and significant changes to the employer’s requirements are unlikely. This means that the contractor is able to accurately price the works they are being requested to carry out.

Advantages: This may lead to higher profit margins. A well-calculated bid can cover all project costs and leave a healthy profit margin for the contractor.

Easy to compare bids. With fixed total costs, employers can choose among bids with ease.

Disadvantages: A potential incentive for the Contractor to cut corners. Since the final cost is set in stone, contractors may wish to cut corners in order to increase their profit margin.

Costs can cut into profits. If contractors are not careful about managing costs, their profit margin may disappear.

2.Unit price contract

A unit price contract, also known as a measurement or remeasurement contract, is based on the number of units necessary for completion. These units are drawn up by the employer’s quantity surveyor in the form of a Bill of

Quantities or Schedule of rates.

Under a Unit Price Contract, a detailed Bill of Quantities or Schedule of Rates forms part of the Contract Documents. Costs are, then, accrued incrementally as the project progresses by means of interim payment applications and payment certificates. The latter is calculated using the unit prices or items in the priced Bill of Quantities or the Schedule of Rates.

Advantages: Simplifies tracking and billing. Rather than billing for labour hours or materials, contractors simply bill for each unit/item.

Supports flexible projects. Projects that have an unknown scope or duration match well with unit pricing.

Disadvantages: Poor pricing can sink contractors. While unit price contracts offer flexibility, a poorly priced unit/item can drop the contractor’s profit.

The Employer does not know the total cost. Although the Employer will know the unit cost, they may not know the total expected final project value.

3.Cost-Plus Contracts

Also known as Cost Reimbursement or Prime Cost contracts. Under this type of contract, the Contractor is reimbursed the prime costs of labour, materials and plant, plus a fee.

Though it can be seen as uneconomical, if built on trust, this type of contract often leads to strong long-time working relationships.

Cost-Plus contracts are three types:

- Cost plus percentage fee: The contractor is paid for prime costs of labour material and plant plus an agreed percentage fee.

- Cost plus Fixed fee: The contractor is paid for prime costs of labour material and plant plus an agreed fixed fee.

- Cost plus Fluctuating fee: The contractor is paid by the

Employer the actual cost of construction plus an amount of fee inversely variable according to the increase or decrease of the estimated pre-agreed cost.

- Target Cost: A target cost contract is a type of cost-reimbursable contract under which the contractor is paid the 'actual cost' (usually defined in the contract) it incurs in carrying out the works, but subject to a target cost which is agreed by the parties at the beginning of the project. However, the payment is based on Pain-Gain share: While a bonus may be paid to Contractor if Target Cost is not exceeded, the Contractor may be penalised if Target Cost is exceeded.

Advantages: Lower risk for contractors. Contractors know their costs will be reimbursed even if prices are affected by inflation. Incentives to manage costs. Both employers and contractors are incentivised to manage the project costs.

Disadvantages: The project’s cost is unknown. The employer does not know the full cost ahead of time.

Meticulous expense tracking. Contractors must carefully track expenses to submit for reimbursement.

4.Guaranteed maximum price Contract (GMP)

Under the guaranteed maximum price (GMP) contract, it is, usually, agreed that the contract sum will not exceed a specified maximum.

Characteristically, this is a mechanism used on design-and-build contracts where the contractor has responsibility for completing the employer’s design and for carrying out the construction works, so they are in a good position to control costs.

If the actual cost of the works is higher than the guaranteed maximum price, then the contractor must bear all the additional costs. Under this type of contract, the contractor feels incentivised to make savings, while the employer has the security of a cost cap.

Advantages: Reduced risk for Employers. Employers know the maximum cost before a project begins. Risk of cost overruns for Contractor. The Contractor must carefully price the project or risk paying out of pocket. Simplifies project for Contractor. Project plans are often finalised before construction, so change orders are minimised. Administrative cost to accounting transparency. Contractors must maintain complicated accounting records for employers to review as part of the contract.

Disadvantages: Risk of cost overruns for Contractor. The Contractor must carefully price the project or risk paying out of pocket.

Administrative cost to accounting transparency. Contractors must maintain complicated accounting records for employers to review as part of the contract.

5.Other types

Other, less used, types of construction contracts are:

- Incentive Contracts: If the project is delivered at a lower cost and/or prior to the contract completion date, the contractor receives extra payment. The incentive is a pre-agreed payment included in the contract.

- Time and Materials (T&M) Contract: This type is used to reimburse the contractor for the costs of the materials needed to complete a job, along with a predetermined hourly wage and other fees related to the service being provided. This type of contract is used when the exact time frame, the overall cost of the project, and the rigidity of the project's terms are unknown to the employer.