What is a construction contract?

In simplest terms, construction contracts are documents that legally bind two parties together. The legally binding agreements in the document explain how the general contractor will perform the work and how the project owner will make the payment. Construction management facilitates their activities through the construction contract.

However, as construction projects vary significantly in size and complexity, no one size fits all approach or template is available to create construction contracts. This is why several types of contracts have been carefully crafted over time, including unit price in contracts, time and material contracts, cost-plus and lump sum.

Irrespective of the type of contract you use, this article will help you understand what a construction contract is, why it is necessary, what to avoid when writing a construction contract and how to facilitate maximum benefits.

Why is a construction contract necessary?

Construction contracts help to protect both parties involved in the agreement. This is because they detail the specifications of the work that needs to be completed and how much payment needs to be made to compensate for that work. This document also outlines all methods of communication and how any disputes would be handled if they emerged.

By including pertinent information about communication, change and compensation, construction contracts help to streamline and simplify the entire decision-making process.

All the risks associated with the project should be anticipated and outlined in the contract with a specific section that describes how to mitigate these anticipated risks. Although a construction contract is firstly and fore-mostly an agreement, it also serves as a roadmap or a guide to all parties involved in the construction project.

Who is involved in the construction contract?

Two parties are involved in the construction contract: the owner and the contractor. Owners are involved in the construction contract because they need to outsource a job, and the contractor gets paid for executing it. Hence, the two parties work in collaboration with each other to draw up the terms of agreement of completion and payment.

Owners contract builders because they cannot perform specialised jobs on their own. They may also contract builders due to the scale of the project and its complexity. Construction projects often require owners to hire several contractors, and in such cases, construction contracts help clarify roles and responsibilities, becoming vital to the successful completion of the project.

Types of construction contracts

As the construction project can take up different formats, it is necessary to craft construction contracts to suit the project’s exact requirements.

A construction contract should ideally define the timeline, budget, quality requirements and other aspects you must cover in every construction project. The construction contract should also outline how the investment is going to be made and how each party is going to assume risks as well as rewards. Before drafting your construction contract, it is essential to have an understanding of different types of contracts so that you can identify the format which best suits your needs:

• Lump sum contract: A lump sum contract, also known as a fixed-priced contract, lists the total price for the entire task. The price stated in the contract accounts for all the materials and the time, regardless of any upcoming issues or changes.

This type of contract protects property owners and the owners of construction companies against unavoidable and unforeseen setbacks or changes. Lump sum contracts can be seen in the construction industry as they favour the owner, but there are many ways to balance the scales. Many contractors tilt the balance in their favour by charging an additional amount to sign the lump sum contract. They negotiate this additional payment as they would be teaching a higher risk. Additionally, owners often put incentive programs into the contract to reward contractors who complete the job early.

• Cost-plus contract: A cost-plus contract contains two parts, accumulated cost and a predetermined fee. This fee is the agreed price that owners pay contractors and can be a dollar amount, a percentage of the total project cost or any other form of payment.

The characteristic feature of a cost-plus contract is that it reports expenses instead of deducting the cost from a set budget. This contract is utilised when the construction project expenses are uncertain and seem like a liability. Additionally, such contracts often include incentives for coming under budget or setting caps on expenditures. This type of contract is significantly utilised as it avoids conflict and ensures that contractors are appropriately paid.

• Time and materials contract: Such contracts are a fitting choice when the project’s scope is entirely unknown. Under such circumstances, contractors charge an hourly rate for labour and per usage of materials. There is so much uncertainty that these contracts must be particular and prepare for almost everything. An owner should include incentives so the construction project is completed ahead of schedule because many contractors will be tempted to drag the project. This type of contract is a good choice for small projects as they require close supervision.

In such small projects, all costs are carefully monitored and classified, meaning the document is highly accurate. This ensures that neither the owner nor the contractor is dissatisfied upon the completion of the project. As you can imagine, comparative evaluation becomes increasingly difficult as the project size increases. Such contracts are used in larger projects; there is a disadvantage of contractors being overpaid.

• Unit pricing contract: A unit pricing contract is utilised when an owner wishes to acquire a large quantity of a particular product. As each product is quantified in units, setting the price per unit makes a lot of sense. As a result of this contract, these items can be bought in bulk quantities for reduced prices.

Such contracts are highly advantageous when an owner knows exactly how much of a specific product would be needed to complete the project. Another advantage of utilising this type of contract is that it protects the owner from any future inflation in material cost. As the owners buy all the items in advance, they generally pay less in the future because they do not have to buy more products or draw up future contracts.

• Design-built contract: A design-build contract is created in cases where the project owners receive the complete design during the bidding process. In such cases, the design and construction are done simultaneously and are addressed with one contract. Traditionally, different contracts are used for design and construction. The advantage of this type of contract is that it increases communication between the construction team and the designer, speeding up the construction process.

• Guaranteed Maximum Price (GMP) contract: A Guaranteed Maximum Price (GMP) contract describes the maximum price a project owner will have to pay for a specific construction project. If the prices exceed the guaranteed maximum cost, the general contractor must cough up and cover all additional expenses.

It is for this reason that this contract requires general contractors to be the most accurate and draft the most appropriate construction estimate possible. Although it sounds risky, general contractors with excellent industry experience and expertise can quickly create accurate estimates using reliable software. Most of the time, these estimates are profitable for the general contractor.

• Incentive construction contracts: As per the incentive construction contract, the project owner and the contractor agree upon an extra payment fee, which is dependent upon the project’s early completion.

In other words, if the contractor can deliver the project on time and within budget, they are awarded an incentive. However, if the contractor misses the time limit, they will still need to complete the project and meet the owner’s requirements without earning that incentive.

• Integrated project delivery contract: Integrated project delivery contract is utilised for large and complex projects. They are similar to design-build contracts, where a single contract is utilised for design and construction. This contract involves a multi-party agreement between the designer, builder and owner, where they agree to share costs and risks and follow lean principles by signing waivers. The main goal of this contract is to provide a detailed framework that evenly presents risks and rewards across all parties.

Construction contract best practices

Irrespective of the type of construction project you are planning, incorporating the following best practices can ensure that your contract is clear, concise and comprehensive. Some examples of best practices include:

• Include incentives: The most effective method to set the construction project up for success is by creating incentives. Incentives are helpful when the scope is undetermined and budget, labour and time cause are exceedingly high. Putting in incentives makes it lucrative for the contractor to finish the construction project on time and within budget.

• Clearly outlined expectations: Be as straightforward as possible when conveying expectations, especially about communication channels, how expenses will be reported and how other aspects of construction projects will be managed. Outlining the contract and breaking it into key points will make it helpful for future reference.

• Create contingencies: The most efficient construction contracts always have a contingency plan. Although not every construction project faces adverse events, more often than not, something unexpected always arises. If you have a contingency plan, the owner and the builder will have a template to refer to if something goes wrong.

What to avoid when writing construction contracts?

The three common mistakes that people make in construction contracts that deem them ineffective include:

• Not being specific enough: Some people make the mistake of generalising their expectations instead of specifying them in the contract. The entire point of a construction contract is to detail the exact terms of the agreement, so there is no room for misinterpretation. However, remember to strike a balance between being too vague and too specific, as too many details stifle the creativity of the contractor.

• Not establishing appropriate communication channels: When writing a construction contract, you must specify precisely how and when the contractor can communicate with you. This can be in the form of regular/periodic check-in or when something significant occurs at the construction project. However, communication channels are imperative to the success and health of your construction project, as both parties must check each other before making decisions.

Lack of effective communication is detrimental to construction projects because there are so many moving parts that the contractor and the project owner must be updated. The well-written construction contract will set up communication rules and where to direct updates and queries.

• Not detailing how to make changes: Every project will inevitably have to undergo some form of change, and construction projects are no exception. A well-crafted construction contract will include a specific section to accommodate changes.

This is because changes do not necessarily mean that there is an obstacle in the road. If contracts stipulate how changes can be made, who makes them, what is the exact process and how to accommodate them, then everything runs smoothly.

On the other hand, if there is no accommodation for such details, contractors would not know how to change when they see an opportunity for growth. Additionally, without such details, the contractors will not understand who they should go to for approval and what documents are needed to make the necessary changes.

We also suggest to read the article “Construction Estimating Mistakes” from Edara App blog.