While construction contracts serve
as a means of pricing construction, they also structure the allocation
of risk to the various parties involved. The owner has the sole power to
decide what type of contract should be used for a specific facility to
be constructed and to set forth the terms in a contractual agreement. It
is important to understand the risks of the contractors associated with
different types of construction contracts (Follow the link to learn further explanation of construction contract template)
Lump Sum Contract
In a lump sum contract, the owner has
essentially assigned all the risk to the contractor, who in turn can be
expected to ask for a higher markup in order to take care of unforeseen
contingencies. Beside the fixed lump sum price, other commitments are
often made by the contractor in the form of submittal such as a specific
schedule, the management reporting system or a quality control program.
If the actual cost of the project is underestimated, the underestimated
cost will reduce the contractor’s profit by that amount. An
overestimate has an opposite effect, but may reduce the chance of being a
low bidder for the project.
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.
Cost Plus Fixed Percentage Contract
For certain types of construction
involving new technology or extremely pressing needs, the owner is
sometimes forced to assume all risks of cost overruns. The contractor
will receive the actual direct job cost plus a fixed percentage, and
have little incentive to reduce job cost. Furthermore, if there are
pressing needs to complete the project, overtime payments to workers are
common and will further increase the job cost. Unless there are
compelling reasons, such as the urgency in the construction of military
installations, the owner should not use this type of contract.
Cost Plus Fixed Fee Contract
Under this type of contract, the
contractor will receive the actual direct job cost plus a fixed fee, and
will have some incentive to complete the job quickly since its fee is
fixed regardless of the duration of the project. However, the owner
still assumes the risks of direct job cost overrun while the contractor
may risk the erosion of its profits if the project is dragged on beyond
the expected time.
Cost Plus Variable Percentage Contract
For this type of contract, the
contractor agrees to a penalty if the actual cost exceeds the estimated
job cost, or a reward if the actual cost is below the estimated job
cost. In return for taking the risk on its own estimate, the contractor
is allowed a variable percentage of the direct job-cost for its fee.
Furthermore, the project duration is usually specified and the
contractor must abide by the deadline for completion. This type of
contract allocates considerable risk for cost overruns to the owner, but
also provides incentives to contractors to reduce costs as much as
possible.
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.
