Types of Construction Contracts and the Change Order Process
In the world of construction projects, there are a few types of contracts used by owners to secure a contractor to provide a service. This depends on the size of the project and the owners risk tolerance. We’ve outlined the three most common below and explained the differences between them. Once a contract has been awarded, inevitably change will occur and requires a change to the original scope of work and the contract. This can be an addition or deduction and you need a way to amend the contract via a formal change order request process. This is can be favorable for you if you run a tight ship and have a formal process in place to track, document and get approval for requested changes. However, this can be unfavorable if you make changes without following the formal process outlined in the contract documents. This can include doing the work on the spot with verbal approval, versus documenting the request and submitting it for written approval and an amended contract before proceeding.
Firm Fixed Price (Lump Sum)
Firm fixed price contracts are commonly used in construction projects where the contractor agrees to deliver a finished product for a fixed price. This includes all labor, material, equipment, and subcontractors needed to complete the agreed upon scope of work. Further, this contract type introduces more risk to the contractor because the contractor’s cost can fluctuate. As a result, there is less risk to the owner because they can control costs. However, this transfer of risk comes at a price. The contractor will likely include some percentage cost associated with carrying that risk as a fixed-price incentive, usually hidden in the fixed price of the contract.
In order to protect the contractor, some lump sum contracts include allowances which designate certain costs to the owner if the contractor goes over budget. Incentives can also be included if they finish early and under budget. But there will be penalties if the project is finished late. This contract is popular with owners who want to control costs with a fixed budget and avoid change orders. In some fixed price contracts, there are delivery incentives for arriving under budget and before or on schedule.
Additionally, clauses can be applied to the contract to protect the contractor in the event of an economic price adjustment. For example, a shortage of copper that causes prices to increase significantly for the item. However, in most cases the contractor usually accepts full responsibility to deliver the project under the total cost of the fixed-price contract.
Cost Plus Contracts
In cost plus contracts, the owner assumes most of the risk because they’re designated to pay for the costs of construction, purchases, and other expenses produced from the project. On top of that, a percentage goes to the contractor for taking on the construction project. In this type of construction contract, the contractor’s risk is minimized because cost overruns whether direct or indirect costs are at the risk for the owner.