If your construction project has a clear and well-defined scope of work and the designer has provided a completed set of construction drawings and specifications, a lump sum contract (also called a fixed price contract) may be mutually beneficial for both you and the owner.
Key Takeaways
- Lump sum contracts are simple, but there are risks for both owners and contractors.
- This type of contract offers very limited flexibility once the agreement is made.
- Contractors must spend the time and money early during preconstruction to properly estimate the project.
How Lump Sum Contracts Work
In a lump sum contract, a price is presented to the owner to complete the entire project for a fixed amount — no more or less. All labor, material, subcontractors, and equipment costs are included in this fixed price and you are not required to perform any additional work beyond what was in the initial lump sum agreement.
Using the contract documents (construction drawings, specifications, owner’s requested schedule, etc.) you’ll estimate the cost of the project plus your markup (overhead costs & profit).
Payments are paid progressively based on the terms of the contract and a certain percentage is held as retainage, to be paid when the scope is completed.
Uses for a Lump Sum Contract
Lump sum contracts are risky for more complex projects, or those that require a lot of demolition before you can fully understand site conditions. On the other hand, they are great when used for projects that are:
- Simple in nature.
- Have a clear set of construction documents (full set of plans, designs, specifications, and schedule).
- Or (if lucky) with a project owner who agrees to a certain percentage of contingency as they don’t want to have as much oversight.
All in all, this type of contract is best used for projects that have a low risk of unexpected costs.
How a Lump Sum Contract Affects Profitability
First and foremost, proper preconstruction is essential for lump sum projects. You should not enter into a lump sum agreement without a complete understanding of the drawings, site conditions, material lead times, and other potential drawbacks. It’s vital to spend ‘smart money’ prior to construction being started so you don’t end up spending ‘dumb money’ trying to fix any errors.
It’s also incredibly important to come in at or below the lump sum price. You should include some padding in your numbers along with a generous contingency in order to protect your bottom line. Anything from site conditions to market conditions (labor shortages, price escalations, etc.) can result in cost overruns and must be best estimated in the contingency to protect your profit.
- Make sure you call each material manufacturer to understand the lead times and costs for expediting.
- Speak to the landlord about site access and any after hours work. Asking subcontractors to work off hours due to noise will increase costs exponentially.
If the preconstruction work is done correctly, the hope is that your actual costs stay as close as possible to your initial cost estimates. If your estimates were inaccurate or you missed something in the pre-con process (which can include anything from miscalculating material lead time, incorrect material counts, a lack of site knowledge or existing conditions, etc.) your bottom line suffers as you will be forced to eat into your profit to cover up for the errors. Some of the things to consider to maximize profit include:
- Labor cost: Communicate with subcontractors so that they understand the schedule constraints and make sure to account for overtime.
- Material cost: Include accurate counts for everything, from raw to finish materials, and ensure the prices are good for long lead times. If not, you’ll need to think about material escalation clauses to cover increases.
- Overhead: Take into account general administrative costs, insurance and any other site administration needed
🔎 Dive Deeper: Learn more about effective construction management on the job.
What is a Variation?
A ‘variation’ is anything that impacts the plan, design errors or commissions to specification changes by the owner and their consultants. Variations will impact the project cost and potentially trigger disputes in the project.
Variations aren’t always bad. Beneficial variations (like a reduction of the scope of the project) can save both the owner and the contractor time and money. From decreasing material quantities to removal of scope, a variation must be clearly outlined as this changes the project scope. Following this, a change order or an amendment to the contract should be issued which redefines the project scope and deliverables.
Common Issues With Lump Sum Contracts
Lump sum agreements are a pretty common construction contract because they are straightforward and easy for both sides to manage and understand. That said, the construction industry is full of surprises, so a simple contract can quickly present several risks if you don’t cover yourself. Two of the major ones are:
- Delays: You must protect yourself against delays that are out of yours or the owner’s control by inserting clauses into the contract. This can cover anything from material shortages to landlord delays, etc.
- Cost fluctuations for labor and materials: These are not typically considered in this type of contract as price is given to the owner as a fixed price in lieu of per unit. To price fluctuations, you can and should increase your margins to cover these inevitabilities.
To reduce these common issues and to reduce the risk of contract disputes, make sure to insert clear language that protects you and your bottom line.
As a review, here are the pros and cons of lump sum contracts.
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Further Reading:
Jarone started his construction career working for a commercial general contractor in Los Angeles, before transitioning to being an Owner's Representative for the past eight years. Jarone has led multiple projects and has been integral in cross-departmental communication and implementation of processes with design, leasing, planning and facilities/operations teams.