Construction contracts explained

Updated April 17, 2017

A contract is an agreement between two or more parties that details their duties and obligations. In the construction industry, thorough, clear contracts are highly important for the completion of successful projects.

Construction Contracts in General

Construction contracts consist of an "offer," or a proposal to do work, made by a contractor; "acceptance" by the project owner and "consideration," usually money in return for the work. The creation of a contract is a process. A bidder includes the terms he would like to set with his offer. An example is a stipulation that the owner will pay for materials on hand before they are installed. Owners typically counteroffer before terms are agreed upon.

Construction contracts define the scope of work for a project, establish work time frames and detail payment agreements. A good construction contract minimises disputes by clearly defining the responsibilities of the parties, as well as standards for acceptable workmanship. Most construction contracts have a section called "General Conditions" containing much of this information. Plans and specifications typically become part of the contract documents.

Types of Contracts

There are two basic contract types: fixed price and reimbursable. With a fixed price contract, the owner pays either a set lump sum for the work, or agreed-upon unit prices for measurable items of work; for example, square feet of concrete.

A reimbursable contract is based on documented actual costs for materials and labour. The owner pays this cost along with a fixed percentage or other agreed-upon fee to cover the contractor's overhead and profit.

Fixed Price Contracts

Contract types are chosen based on project needs and market conditions. If the project's scope can be clearly defined, with quantities that are straightforward and measurable, owners take on less risk by bidding the work at fixed prices. This allows an owner to understand the probable final contract cost at the start of the project. Competition among the bidders keeps the costs as low as possible.

Reimbursable Contracts

There are times when the scope is less clear. Suppose an owner needs a contractor to pump water off the job after it has rained. Guesses can be made about how much it will rain, but it is not possible to know in advance how much work will be needed. In cases like this, a reimbursable agreement is equitable.

Reimbursable contracts are also used when a project has a long duration, or when market prices are unstable. Locking in the unit price for asphalt, for instance, is difficult on a long-term project, since asphalt prices can be volatile.

Pros and Cons

While an owner is at less financial risk with a fixed price contract, risk cannot be totally avoided. Quantities are only estimates at the outset. If as-built quantities are larger than the original estimates, the total contract cost increases.

For an owner wanting to get a project started quickly, fixed price contracts can mean later construction starts. The work cannot be bid without a clearly defined scope. Plans must be complete and the project tightly defined before the bid process can begin.

A contractor in a fixed price contract has incentive to perform. The more efficiently the work is completed, the less it will cost the contractor. Since this directly influences profits, he is likely to devote more resources to a fixed price project.

The owner carries far more risk in a reimbursable contract. Since the contractor will not lose money in a "cost-plus" situation, there is no incentive for finishing on time. His inefficiencies will be paid for by the owner, so controlling costs becomes the owner's responsibility. The owner usually needs more project supervision to control the outcome, adding expense.

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About the Author

Donna Bogren has been a freelance writer since 2008. Her background includes 30 years in construction management, a frequent topic of her articles published by Demand Studios. Her work has been published in "Critter" magazine. She also writes grants and marketing materials. Bogren's degree in civil engineering technology was earned at Michigan Technological University.