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By Roy Rasmussen Updated on October 14, 2021

Construction Contract Basics: Essential Tips (Plus Why They’re Important)

Knowing construction contract basics can help you negotiate good deals and protect your rights. 

Here’s our guide to the essentials. We’ll cover what construction contracts are, why they’re important, what the different types of contracts are and what they should include.

What Is a Construction Contract?

A construction contract is an arrangement between a contractor and property owner in which the two parties agree that the contractor will build a structure in return for payment from the owner. This construction agreement is formalized in a bundle of documents that lay out the terms of the arrangement.

The most basic construction contract document in the bundle is the construction contract agreement. This document summarizes the essence of the contractual agreement and specifies key details such as:

  • Who the contractor is
  • Who the property owner is
  • When the project will begin

Other documents attached to the construction contract agreement flesh out details such as:

  • The scope of work
  • The schedule for the project
  • The rights and responsibilities of the parties involved
  • Cost estimates 

The full collection of documents, including the construction contract agreement and its various attachments, constitutes the construction contract.

Why Are Construction Contracts Important?

A building construction labor contract agreement performs several important functions, including:

  • Documenting the agreement between the contractor and property owner
  • Laying out the legal rights, responsibilities and risks each party is accepting
  • Defining the exact scope of the work to be performed
  • Setting a timetable for the project
  • Specifying the amount to be paid for the project
  • Identifying who is responsible for paying additional fees if the project costs more than estimated and who can keep any extra funds if estimates exceed actual costs

By performing these functions, a construction contract serves to protect the rights of both the contractor and the property owner. It facilitates transparent communication about project scope, cost and timetables, providing both parties with a written reference as to what was agreed upon. This helps avoid disputes while providing legal documentation if disagreements do arise.

A crane hoists a large document that reads “Construction Contracts” toward a construction worker wearing a hard hat.

What Are the Different Types of Construction Contracts?

There are several different types of construction contracts that differ based on:

  • How fees are calculated
  • Who is responsible for paying when project costs exceed estimates
  • Who keeps excess funds if costs fall short of estimates

Some of the most common types of construction contracts include:

  • Lump-sum construction contracts (fixed-price contracts)
  • Time and material (T&M) contracts
  • Cost-plus contracts (cost-reimbursement contracts)
  • Unit pricing contracts
  • Guaranteed maximum price (GMP) contracts

Each of these types of contracts has its own best uses, pros and cons.

Lump-Sum Construction Contracts

A lump-sum construction contract is one of the most basic building contract formats. It specifies a fixed price to be paid for a project regardless of what actual costs run. This can be an advantage for the contractor if the project runs under budget because they get to keep the difference. However, a con is that if costs outrun estimates, the contractor has to eat the loss.

From the property owner’s side, this type of contract runs the risk of paying too much if the contractor overestimates a project. For these reasons, a lump-sum contract is best for standard, small projects where costs can be predicted with reasonable accuracy. For example, a project for a retail chain that always uses the same design for its locations can be estimated with a high degree of accuracy.

Time and Material Contracts

With T&M contracts, contractors bill based on an hourly or daily pay rate plus the cost of materials. This allows contractors flexibility if time and material cost estimates diverge from actual labor and expenses, but it requires strict record-keeping and offers no incentive for finishing ahead of schedule.

For property owners, this type of contract runs the risk of unexpected fees or delays. Note that T&M contracts are most suited for situations where costs can’t be estimated with a high degree of accuracy.

Cost-Plus Contracts

With cost-plus contracts, also known as cost-reimbursement contracts, the contractor is guaranteed their expenses plus a profit, which may be a fixed fee or a percentage of the project cost. This provides contractors with flexibility if estimates prove inaccurate, without incurring the risk of paying the difference for underestimates as with a lump-sum contract. 

However, because contractors rely on reimbursement to cover costs, they may struggle to fund expenses upfront. This could create a cash-flow crunch and trigger construction financing issues.

For owners, cost-plus contracts run the risk of footing the bill for unforeseen expenses. This type of contract is best suited for situations where costs are difficult to anticipate and flexibility is required.

Guaranteed Maximum Price Contracts

GMP contracts place a cap on the price for a project. For contractors, this can expedite the process of winning a bid, and it provides an incentive for finishing under budget. However, it runs the risk of absorbing costs if projects run over budget.

For property owners, a risk is overpaying based on overestimates. GMP contracts are best used when costs can be estimated accurately.

Independently of GMP contracts, GMP clauses may be included in other types of construction contracts specifying price caps for projects.

Unit Pricing Contracts

Unit pricing contracts break projects down into units, each with its own estimates and costs. 

For contractors, this simplifies billing and makes it easier to control profit margins. However, it can make it difficult to estimate project costs, and it can delay payment until expenses are tallied, creating cash-flow issues.

For property owners, unit pricing contracts run the risk of incurring unexpected fees. This type of contract is best when costs aren’t easy to estimate and depend mainly on materials costs.

Two hands, one from a construction contractor wearing work gloves, the other from a business professional, shake. A factory is under construction in the background.

So, What Should Be in a Construction Contract?

The bundle of documents in a construction contract should cover a number of main points. 

These can include:

  • The construction contract agreement, which lays out key details such as who the parties entering into the contract are and when the project will begin, in addition to serving as a reference point for other documents in the contract bundle
  • The scope of work (statement of work), which delineates items such as what work will be done, who will do it, how it will be done and what materials will be used
  • The project schedule, including projected completion date and procedures which will be followed if there are delays
  • General conditions of the contract, specifying which rights and responsibilities each party agrees to and how disputes will be handled
  • Special conditions of the contract, which expand on the general conditions by covering specific situations, such as conditions that only apply to a certain part of the project
  • Technical specifications about which techniques and materials will be used on the project
  • An itemized list of trades and materials that will be employed on the project
  • A cost estimate, which may be broken down into as much detail as desired
  • Drawings depicting the work to be done, which can take the form of detailed blueprints or more general depictions
  • A Construction Specifications Institute (CSI) MasterFormat outline, which lays out project specifications according to industry-recognized standards covering construction requirements, projects and activities
  • Insurance coverage details specifying which types of insurance protection are being provided on the project

Note that some of these items may be omitted from certain contracts. For example, itemized lists of trades and materials may be requested for bids but aren’t always required.

Can You Negotiate Construction Contracts?

Construction contracts for private sector projects generally are open to negotiation Those for public projects generally aren’t, being restricted by competitive bidding regulations. 

An attorney specializing in construction law can help you review and negotiate your contract to make sure you’re getting a good deal.

Know the Contract Basics to Protect Your Rights

Construction contracts are agreements between contractors and property owners in which the contractor promises to build a structure in exchange for a fee. 

These agreements are formalized in bundles of documents that set forth the basic agreement along with key details such as project scope, cost estimates and the rights and responsibilities of the respective parties involved. Construction contracts benefit all parties involved by providing transparent documentation of agreements, work scope, schedules, costs and the rights and risks assigned to each party.

Note that different types of construction contracts vary based on:

  • How fees are calculated
  • Who’s responsible for covering costs that exceed estimates
  • Who gets to keep funds when costs fall short of estimates

Also, some types of contracts use fixed fees, while others allow more flexibility for unanticipated expenses.

Construction contracts should include documents covering essential items such as construction contract agreements, scope of work, project schedules and cost estimates. As a best practice, consult an attorney specializing in construction law to make sure all your bases are covered.

Roy is a respected, published author on topics including business coaching, small business management and business automation as well as an expert business plan writer and strategist.
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