Types of construction contracts/The Nature of Construction Contracts
A contract is an understanding made between two or more persons, by which rights are acquired on the one side to acts or forbearances on the other. To make an agreement which results in a contract, there must be an offer and acceptance which leads to a binding force of obligation.
Lump sum contract
A lump sum contract is an agreement pursuant to which one party consents to pay another party a set dollar amount for completing the work or providing the goods described in the agreement. Typically, lump sum contracts do not require contractors to provide a detailed breakdown of costs. Rather, the payment of the total contract price is linked to the contractor completing all of the work specified in the contract.
Under this arrangement the contractor is reimbursed for the actual cost of labor and materials, plus charges a fee (typically an agreed-upon lump or percentage of the total costs) for overhead and profit. This arrangement seldom begins with a blank slate regarding specifications and costs. Rather, the consumer and contractor will create a list of specifications and an estimated budget to match to those specifications. Although the contractor under this arrangement will have to keep copious records of its costs, most residential consumers in a cost-plus arrangement suffer from kid-in-a-candy storeitis and overspend. One way to prevent breaking the budget is to set a guaranteed maximum price. However, even a maximum price will not alleviate problems.
Unit Price Contract
In a unit price contract, the risk of inaccurate estimation of uncertain quantities for some key tasks has been removed from the contractor. However, some contractors may submit an “unbalanced bid” when it discovers large discrepancies between its estimates and the owner’s estimates of these quantities. Depending on the confidence of the contractor on its own estimates and its propensity on risk, a contractor can slightly raise the unit prices on the underestimated tasks while lowering the unit prices on other tasks. If the contractor is correct in its assessment, it can increase its profit substantially since the payment is made on the actual quantities of tasks; and if the reverse is true, it can lose on this basis. Furthermore, the owner may disqualify a contractor if the bid appears to be heavily unbalanced. To the extent that an underestimate or overestimate is caused by changes in the quantities of work, neither error will effect the contractor’s profit beyond the markup in the unit prices.
Target Estimate Contract
This is another form of contract which specifies a penalty or reward to a contractor, depending on whether the actual cost is greater than or less than the contractor’s estimated direct job cost. Usually, the percentages of savings or overrun to be shared by the owner and the contractor are predetermined and the project duration is specified in the contract. Bonuses or penalties may be stipulated for different project completion dates.
Guaranteed Maximum Cost Contract
When the project scope is well defined, an owner may choose to ask the contractor to take all the risks, both in terms of actual project cost and project time. Any work change orders from the owner must be extremely minor if at all, since performance specifications are provided to the owner at the outset of construction. The owner and the contractor agree to a project cost guaranteed by the contractor as maximum. There may be or may not be additional provisions to share any savings if any in the contract. This type of contract is particularly suitable for turnkey operation.