This article is written by Chinmay Lenka, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
Table of Contents
Introduction
Construction agreements are used for various kinds of projects, including but not limited to, construction of building structures, construction of bridges, railway tunnels, railway line structures, roads, flyovers, digging up of canals, restructuring of internal structures of the buildings and more. The aim of these contracts is to provide clarity to all the parties involved in the construction of a structure, with respect to their duties, obligations, penalties involved in case of breach of contracts, the breakdown of cost and payment schedules involved, the timeline of various phases of the construction to abide by and more. To understand the relevance and utility of the construction contracts in the real estate sector, let’s take a look at the top 5 most used construction contracts, which are as follows:
Lump Sum contracts
Lump sum contracts are the most commonly used contracts in the construction industry. The reason for their popularity is the fact that they outline one fixed rate/ price for the kinds of work to be done under the contract. In fact, contractors enter into the lump sum contracts very regularly.
However, even though the outline of the contract is quite simple, the contracts are usually not so simple to understand and come with their own set of positives and negatives.
When to enter into Lump sum contracts
There are multiple projects where the parties can enter into a lump sum agreement. The key factors that the parties involved need to keep in mind before entering into a Lump sum contracts are:
1. Whether there is a clearly defined scope of work?
2. Whether the project and the work involved is relatively straightforward to complete?
If the answers to both these questions are in the affirmative, then entering into a lump sum contract would be ideal for the parties involved. For more complicated projects, like building a commercial building which is a relatively long-term project and would involve a lot of alterations according to the parties’ needs, a lump sum contract is not an ideal match.
Time and Materials contract
Time and Materials contract (T&M) are used for relatively complex and longer projects where the scope of work is not straightforward and well-defined. To simply understand the basics of a T&M contract, here the contractor gets reimbursed for the cost of the materials and separately for the cost of the hourly wages of the man force employed to complete the project.
When to enter into a Time and Materials contract
The answer to this is a bit unpredictable but there are certain guiding factors to consider before deciding on whether or not to get into a time and material kind of an agreement. The factors are the following:
1. Where the scope of work is not clearly defined and it can alter with the advancement of the project.
2. Where it can be hard to narrow down the time and material to be utilised for completion of the project.
These factors are essential for the contractors and the owners because when the time and cost of the material fluctuates, going for separate reimbursements can help avoid conflicts and bring more efficiency in the decision making involved with the completion of the project.
Now let us understand the major pros and cons of entering into a Time and Materials contract:
Pros
1. Scope of Time and material is easier to ascertain: Since there is a clear division between the payment for the materials and the payment of the hourly wages, instances like unexpected delays, change in scope of work are ascertained and covered accordingly.
2. There are simple negotiations: Due to the clear division of wages and materials, simpler negotiations are an added advantage.
Cons
1. Keeping track of time and materials is exhaustive: If the data regarding the material cost and the time is not accurate, it can lead to lesser profit margins. Keeping track of each material and the time/ hourly work done is hard.
2. Projects are not completed ahead of schedule: Since the hourly work rates and materials rate is fixed already, there is no real incentive for completing the projects early on.
Cost-Plus contracts
Cost-Plus Contracts, alternatively known as cost-reimbursement contracts, involve the owner paying the contractor the costs involved in the completion of the project plus a particular amount of money as profit for completion of the project, the profit paid is usually a particular percentage of the total price of the contract.
The cost covered is the direct costs (labours and material used), indirect costs (travel, food and beverages, accommodation and more), and the profit (the agreed upon profit to be paid). There are certain pros and cons of the Cost-Plus contracts, which are:
Pros
1. The contracts are quite budget friendly for contractors as they do not have to worry about the quality of the material to be used in the construction, as the material cost is also covered by the owner.
2. The calculation of margins is not too difficult as the contractor is getting an additional amount of money and the direct and indirect costs are already covered by the owner.
3. The property owner can put a limit on the amount of expenditure that is to be incurred on the completion of the project, as the direct and indirect costs are coming out of his paycheck.
Cons
1. There can be a difficulty for the contractor to justify certain expenses and costs incurred during the construction. Similarly, it can be hard for both the parties to keep a track of the expenses incurred during the project.
2. Accounting for indirect costs can be challenging. The contractor will incur various administrative expenses and expenses related to food, accommodation, travel and more and the owner is usually not too happy to account in and reimburse such expenses.
Unit Price contracts
Unit Price contracts also known as measure and pay contracts are the kind of construction contracts where the work is divided into separate units or phases. Here the total cost of the contract is based on the cost of the individual units or chunks of the agreement. Here the contractor provides for the rate for completion of a specific unit of work, out of the entire agreement. The margins coming out of the project are determined on the units of the project, rather than the final product after the construction.
How is the pricing of the individual units done
The common factors that go into pricing a particular unit. Here are a few major chunks that are to be seen for viewing the entire cost of the chunk.
– Cost of Labours
– Cost of Materials
– Overhead Costs
– Profits earned
– Applicable taxes
– Permits and Cost of Inspection
With the pricing of each unit, the contractor has a fair idea of the break even price and the kinds of margins to be expected out of the completion of the work unit.
When should one enter into a Unit-Price contract
A few factors need to be considered when entering into such an agreement. Such an agreement can be beneficial when the scope of work of the entire project can be split into identifiable units with their own set of scope of work involved. Or when the amount of work cannot be identified from the start and the project is a long duration one, with possible fluctuations.
Guaranteed Maximum Price (GMP) contracts
GMP contracts entail a maximum price of the entire project and the payments are not to be made to the contractor exceeding the Maximum Price. All the labour and material costs incurred are to be born by the contractor.
Many times, there is a GMP provision in other kinds of construction agreements. For example, a cost-plus contract or a Time and materials contract may include a GMP provision. GMP contracts are best suited for projects where a few variables are unknown or the project entails a scattered scope of work. There are certain pros and cons of a GMP Contract, which are:
Pros
1. GMP allows for quicker completion of projects: Since the maximum price of the project is already known, the financing of the project and the bidding for the project is smoother and faster.
2. GMP allows promotion of cost savings: Since the margins are forecasted early on, it is easier for the contractor to finish the project early on by cutting costs and saving time in the completion of the project.
Cons
1. Risk on Contractors: In case the costs of completion of a project exceeds the Maximum price, then the entire cost is to be borne by the Contractor.
2. Longer Negotiations: A lot of times the GMP is not suitable for the contractors according to their expected margins. This leads to the negotiation between the parties to increase the GMP of the project or look for possible alternatives.
Conclusion
The aim of this article was to make sure the readers understand the various kinds of agreements which are applicable to a large number of projects, with varying needs and complexities of their own. The construction/ real estate sector is filled with challenges related to contract enforcement and the disputes coming out of poorly worded construction agreements, hence it is necessary to choose any of the above listed agreements or to combine the qualities presented in the agreements presented above and make a formidable, watertight construction agreement.
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