Construction Contracts Explained
Updated: Oct 6, 2019
The terms “estimate”, “bid “, and “contract” are sometimes confused, but have important differences. An estimate is an educated guess based on a general description of a project. A bid is an estimate based on a more specific description of work to be done. A contract is a binding agreement to do specified work for specified compensation. Therefore, neither estimates nor bids are binding, until they are turned into contracts.
Construction contracts generally fall into two types: fixed price or cost-plus. There are significant differences between the two, and it’s worth understanding them both to decide which is more suitable for your project.
Fixed-price: The Contractor agrees to complete specified work for a specified sum. Regardless of the Contractor’s actual cost to complete the work, the cost to the Owner does not change. For example, a painter will paint the exterior of a house for $10,000. The contract will specify exactly what parts of the house will be painted, what preparation will be done, the type of paint to be used, how many coats, etc. Whether it takes the painter one week or three months to complete the work, the price will stay the same.
In this arrangement, the Contractor is paid for the cost of the work, plus a percentage for profit and overhead. Cost means what the Contractor actually pays out to his employees, Subcontractors, and suppliers. The Contractor makes money by marking up labor, materials, and Subs according to an agreed percentage (typically 10-20%).
A cost-plus contract is essentially an agreement to reimburse the Contractor for costs he incurs while building your project. The contract can range from having no construction specifications to having as complete a set as a fixed-price contract. For example, hiring a painter “by the hour” and paying him for materials he purchases is a simple cost-plus contract. The amount of money paid to the Contractor directly correlates to the time it takes him to complete the job. While the Contractor may provide a detailed estimated of both time and cost, he is not contractually bound to meet the estimate.
Comparing Fixed-Price (FP) and Cost-Plus (CP)
Cost Control: The most obvious and significant advantage of FP is knowing the total project cost up-front. In cases of bank financing or tight budgets, this is the only way to ensure that the project won’t exceed the budget (of course, there are lots of exceptions, see change orders below). The open-ended nature of CP contracts make them difficult for most Owners to accept, particularly on larger projects.
Flexibility: If you want flexibility to change the design or materials used during the building process, CP offers far more flexibility that FP. Any change to a FP contract must be handled through a change order, a costly and time consuming process. With CP, the Contractor is happy to make a changes, since he’s paid hourly regardless of the work performed.
Owner- Contractor relationship: The type of contract can impact the relationship you have with the Contractor. In a FP contract, the Owner and Contractor have different goals; the Owner would like the Contractor to interpret the specifications generously, and include items that may not be directly specified. On the other hand, the Contractor’s interest is to comply with the specifications and not do unpaid “extras”. In CP, the Contractor does whatever the Owner asks. Essentially, CP puts the Contractor and Owner on the same team, while FP puts them on opposing teams.
Cost-effectiveness: The assurance of a price that cannot go higher makes FP a popular form of contract, since most people dislike surprises (particularly those involving thousands of dollars of increased cost). However, it’s worth taking a closer look to see if a FP is really a good value.
From the Contractor’s standpoint, an estimate is just a guess, based on experience, of how long a project will take. Because projects often take longer than planned, she includes a contingency cost in her estimate. If the house should take four weeks to paint, she will probably add an extra week of contingency. Assuming her weekly rate was $1000., her actual estimate would be $4000., but her price to you would be $5000. That way, if the job does take a week longer than expected, she still gets paid for her time. If the job goes as planned (four weeks), you’ve paid for an extra week of time. In a CP agreement, you would pay just $4000., but you could pay far more if it took a lot longer. In this way, a FP contract is like an insurance policy- you pay extra up-front to protect yourself against potentially greater costs later.
Importance of Specifications: Fixed-price contracts are dependent on unambiguous specifications to ensure contract compliance. If there is any wiggle room in the language that describes what work is to be done, you may find yourself getting less than what you thought you paid for. You don’t want to pay for a Lexus and get a Hyundai! It is time-consuming and costly to develop iron-clad specifications for all the work-items to be completed in a building project. Cost-plus contracts may also require accurate specifications, but they do not need to be as detailed, because they can be easily added to or amended during the building process.
Besides the cost of developing specifications, there is the issue of enforcing them. On large buildings, a “clerk of the works’ spends all day making sure that the work is being done correctly. On residential work, this is impractical, so most work is completed without any oversight. If the painter says he put the paint on correctly, can you prove otherwise? While this may be an issue with CP, the incentive to work faster and perhaps sacrifice quality is inherent in FP.
In fact, most fixed-price project disagreements center on whether or not the Contractor complied with the specifications. Owners may find that the simple appeal of fixed-price- a set price for a set piece of work- becomes more complicated as disputes arise.
Change Orders: A change order is the mechanism to amend the specifications (and usually the cost) of a FP contract. For example, if the painter was hired to paint four rooms for a fixed price of $1000, adding a fifth room would require an adjustment to the specs and an increase in cost. Most change orders are initiated by the Owner, adding features to the project as it unfolds. However, some change orders are requested by the Contractor based on an ambiguity in the specs. For example, the painter may ask for a change order (and more money) to fill nail holes before painting. While the Owner may have assumed that this work was included, unless it is specifically stated in the contract, the painter is not required to do it. Projects with incomplete or poorly written specs can result in significant cost-overruns due to change orders. They are often the nexus of conflict between the Owner and Contractor, as they represent the intersection between two different interpretations what work was included for the fixed price.