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A key component of survival and profitability in the construction industry is understanding how to manage risk through careful scrutiny of key contract provisions and calling on counsel for assistance in negotiating and drafting contract provisions in order to clarify rights and duties and fairly allocate risk among the contracting parties. A well drafted construction contract lays the foundation for a healthy working relationship and a profitable job. Such contracts will clearly define key terms and issues including the scope of work to be performed, the price, the terms and conditions of payment, and the allocation of any foreseeable risks.
The beginning of the contract process usually coincides with the bid. The bidding process is a crucial point; mistakes during the bidding phase related to the pricing of the job can be ruinous to the unwary bidder. Success ultimately depends on developing and applying the most accurate cost estimate in order to calculate the lowest possible bid that will ensure some margin of profit. Contractors that are able to consistently make such calculations accurately are best positioned for long term success.
Contracts are often priced according to one of the various methodologies under the two fundamental types of contract payment structures: fixed price and cost reimbursement. As the name implies, fixed price contracts are agreements to pay a firm price that is negotiated prior to the start of work. A fixed price contract might take the form of a lump sum or a unit price.
A lump sum is an agreement to pay a fixed price that is set before the contract is officially awarded. Such agreements are generally not subject to any adjustment unless there are changes to the scope of work. In the case of overrun, the contractor bears any overages for labor or materials. The unit price method instead fixes a price for a specified unit of work—for example, a per square foot price—with the total price calculated by multiplying the unit price by the number of units completed.
Cost reimbursable method make take the form of an agreement to pay all of the contractor’s actual labor and material costs plus a marginal amount for profit, such as 20 percent. This type of pricing is often called “cost plus” or “cost plus fee” pricing.
A buyer-owner will generally prefer fixed price contracts because of the certainty they provide in terms of project cost. On the other hand, contractors should prefer cost reimbursable contract pricing to minimize the risk of reduced profit margins or projects that become unprofitable altogether. A contractor can potentially profit equally from either pricing method, but fixed price contracts create a heightened need for accurate up-front cost predictions and careful management of change requests during the project to keep the budget on track.