As construction projects vary in terms of scope, delivery, schedule, budget, and the parties involved, there isn’t a one-size-fits-all approach to contracts between owners and general contractors. Using the right contract for the right kind of project is critical to making sure you stay profitable, and that you can protect your company's best interests.
Below we'll walk through the different types of construction contracts, the types of projects they're best suited for, and some of the risks to watch out for with each contract type.
There are eight standard types of construction contracts:
Which contract type is best? As with most things, it depends. The type of contract you and the owner agree to use will vary based on the job, its requirements, and the needs of the owner. Here’s how it usually boils down.
The other three are less common and are used in specific situations. Let's dive into the different types of contracts and the pros and cons below.
👉🏼 Contracts rely on an accurate scope of work to be effective. Read how to write an effective scope of work for construction projects to make sure yours are setting you up for success.
There are five types of contracts most construction firms lean towards. Here’s a breakdown of the benefits and drawbacks of each one.
For projects with a well-defined scope of work, lump sum contracts (also called fixed price contracts) are straightforward. This type of contract establishes a fixed fee that you’ll be paid for all materials and labor to complete the entire project. As a contractor, this can place more risk on your shoulders because it depends on your estimates being accurate and your scope of work being very clear on what is and isn’t included. Unforeseen costs will quickly eat into your profit margin so bidding on this type of contract typically becomes a Price is Right game of bidding as high as you can without losing it.
PRO – This type of contract benefits the owner during the bidding process because it’s easy to compare bids of a lump sum cost versus an itemized list. These types of contracts also don’t usually require as much owner supervision.
CON – If you aren’t thorough in your preconstruction and estimating work, there is a high risk of the project being over budget and cutting into your profit margin. Lump sum contracts also don’t factor in issues like site conditions, material cost fluctuations, or change order requests from the owner. This isn’t necessarily a bad thing, but it does require your project management team to be very diligent in tracking any changes that go out of scope so you can maintain your margin.
👉🏼 Read more about how lump sum contracts work in construction.
A guaranteed maximum price (GMP) contract is similar to a lump sum contract in that the total price of the job is agreed upon ahead of time. The difference is that, in a GMP contract, project owners can benefit from some of the cost savings if the final cost is under budget, which isn’t great for contractors. On top of that, any costs that come up that exceed that maximum amount are your responsibility and the owner will not be liable. As such, you act as a construction manager at risk (CMAR) who must diligently oversee the project to ensure your actual costs aren’t exceeding the budgeted costs.
PRO – On the owner’s side, this type of contract clearly defines how much they will have to pay. It includes all costs (and profit) and at times minimizes change orders as project plans are fully developed before starting construction.
CON – The risk is mostly on your shoulders, so you have to keep a close watch on construction costs associated with each line item. This can be a positive too, but the preconstruction phase and estimating are critical here.
👉🏼 Read more about how GMP contracts work in construction.
For projects with some uncertain project expenses, cost-plus contracts reimburse you for all your costs plus your markup during construction. Cost-plus contracts aren’t a blank check. They typically require an estimate at the start of the project so the owner knows what to expect and if you go too far outside of that initial estimate, it could damage your reputation with the owner. However, this type of contract does work well for projects where the scope is unclear and you are unable to be exact in your initial estimate.
PRO – Instead of running a declining budget, you can track and report expenses as they occur on the job site. Your risk is lower because even if unexpected costs come up you can charge for them.
CON – Along with meticulous expense tracking for reimbursement, you can’t possibly know the total project cost ahead of time, which can lead to awkward situations with the owner. On top of that, some of these contracts include “not to exceed” clauses which hamper how much you can spend.
👉🏼 Read more about how cost-plus contracts work in construction.
Under a time and materials (commonly known as T&M) contract, the owner will reimburse you for an agreed-upon price for time and materials plus your profit margin. Similar to a lump-sum agreement, T&M contracts are pretty straightforward while allowing for flexibility in the cost of materials and labor rates.
PRO – Mitigates your risk because it allows for changes due to fluctuating material and labor costs.
CON – Unless there is a not to exceed (NTE) clause, there is an increased risk for owners. Disputes also can arise between you and the owner if the price of materials or labor rises.
👉🏼 Read more about how time and materials contracts work in construction.
A unit price contract details prices per unit. The owner will pay you based on agreed-upon rates per unit for labor, materials, supplies, overhead costs, profit, and more. For example if a contractor is hiring X laborer, there is a fixed cost for their hours or if they buy Y material, there is a fixed price for the multiples of the material. This type of contract is helpful for situations where the volume of units needed is unknown and it provides transparency of costs for additional labor, material, etc.
PRO – Since each variable is a fixed cost, tracking and billing is much easier than in other types of contracts. It is also useful for jobs that have an unknown duration or scope.
CON – Owners can be very wary of this type of contract because they won’t know the full project scope at the beginning and cannot properly run a declining budget. As the unit costs multiply as the project proceeds, they will not know the total number and units required. And on your side, while it provides transparent cost structures, it doesn’t allow for flexibility in raising any of the unit costs during the project.
👉🏼 Read more about how unit-price contracts work in construction.
There are a few other types of contracts that you may want to consider using in different situations and types of jobs.
Instead of addressing design and construction as two separate processes, the design-build contract addresses both sides simultaneously. This type of contract speeds up the process but can lead to higher costs because it eliminates the competitive bidding phase. The process definitely saves the owner time at the onset, but the downside is that it is impossible to get an accurate final price when the project is kicked off.
As the name suggests, the incentive construction contract provides an incentive if you can deliver the project by a certain date and do so under the agreed-upon cost. These contracts can help create a collaborative process but require more negotiations to determine the incentives and milestones.
Relatively new to the construction industry, this type of contract is a multi-party agreement between the owner, designer, and builder. Integrated project delivery contracts (IPD) spread out the risks and rewards and are popular for those who want to embrace collaboration. In this type of contract, all stakeholders agree to a lump sum profit if the project meets its designated financial outcomes.
To review, here's a breakdown of the pros and cons of the different contract types.
| Contract Type | Pros | Cons |
| Lump Sum | Easy for the owner to compare bids of a lump sum cost versus an itemized list. These types of contracts also don’t usually dictate as much owner supervision. | Don’t factor in issues like site conditions, material cost fluctuations or change order requests from the owner. A contractor will be locked into a target profit margin and more inclined to submit change orders for any deviations from the original design. |
| Cost-Plus | Contractors can track and report expenses as they occur on the job site. Your risk is lower because even if costs rise you’ll be protected. |
You must meticulously track expenses for reimbursement. Some of these contracts include “not to exceed” clauses which hamper how much you can spend. |
| Time and Materials | Mitigates the risk for contractors as it takes into account fluctuating material and labor costs. And since the owner will see costs of both, it limits any cost-cutting methods. |
Disputes also can arise between owner and contractor if prices of materials or labor rises. If the you put an initial allowance in a budget, it can also eat into your profit margin. |
| Unit Price |
Tracking and billing is much easier than in other types of contracts. Useful for jobs that have an unknown duration or scope. |
Doesn’t allow for flexibility in raising any of the units during the project. |
| Guaranteed Maximum Price | Owners appreciate the clear definition of how much they will have to pay | The risk is mostly on your shoulders and the preconstruction phase and estimating are critical here. |
The construction process is inherently high-risk for contractors and proper risk management starts with a solid understanding of how different types of contracts can increase that risk. Of course, owners are also assessing their own risk when they hire you to complete a job, so you have to balance all of that with your ability to win bids.
Regardless of the type of contract you choose, make sure to read through each condition carefully. And remember, there is no ‘perfect’ contract, each has its own benefits and drawbacks. Just make sure you and the owner understand the contract terms clearly before you sign on the dotted line.
Further Reading: Foundations of Construction Management for SMBs