All construction contracts address critical aspects of a project, including its scope ofwork, price and payment terms, schedule and an explanation of each party’s rights andresponsibilities. However, lump sum contracts have specific criteria that can be both abenefit and a hindrance to a construction project.
What Is a Lump Sum Contract?
Under a lump sum contract, also known as a stipulated sum contract, the project ownerprovides explicit specifications for the work, and the contractor provides a fixed price forthe project. These contracts require the owner to complete the project’s plans,designs,specifications and schedule before the contractor can establish a price. The contractor thenestimates the costs of materials, tools, labor and indirect costs such as overhead andprofit margin and provides a quote.
If the project’s final costs are lower than the contactor’s estimate, then theirprofitincreases. If the estimate is too low, the contractor’s bottom line suffers. However,theproject owner’s finances are unaffected in either scenario.
So, what does lump sum mean in a contract? Despite the “lump-sum” moniker, thisterm refersto how the project is priced rather than the payment terms. With these contracts, paymentusually occurs on an installment basis. This can be as project benchmarks are met or inregular increments (e.g., monthly).
To modify a lump-sum contract, project owners must submit a change order document that thecontractor must approve along with any price changes. That makes lump-sum contracts somewhatinflexible, but they provide a reliable price for owners and reliable revenue forcontractors, making them one of the most popular types of construction agreements.
Contractors and project owners often wonder, “what is the difference between fixedprice andlump sum contracts?” Simply put, these terms are interchangeable and are two names forthesame concept. However, there are some crucial distinctions between lump sum contracts andother construction agreements.
Lump Sum vs. Cost-plus Contracts
Cost-plus contracts are similar to lump sum contracts in that the owner agrees to pay thecontractor’s costs, including labor, subcontractors, equipment and materials and anamountfor the contractor’s profit and overhead. But instead of a lump sum to cover all theexpenses, those costs are reimbursed individually.
These agreements do not require the project owner to have finalized plans for the project.That means that the scope and cost are subject to change. Unlike lump-sum agreements, ownerstake on more risk and will benefit or be disadvantaged if the final costs are lower orhigher than estimated as they are directly reimbursing the contractor’s expenses.
There are three types of cost-plus contracts:
- A cost-plus-fixed-fee contract where the contractor is paid a base amount independent ofthe final project cost.
- A cost-plus fixed fee with a guaranteed maximum price contract where thecontractor’scompensation is based on a fixed amount that does not exceed a specific threshold.
- A cost-plus fixed percentage contract where the contractor’s compensation is basedon apercentage of the cost.
These contracts are most common when designs, plans or other specifications are still influx, but the owner still wants to begin construction, such as when the project is on atight schedule.
The main advantage of cost-plus contracts for both owners and contractors is that the worklikely gets done to specifications because the contractor won’t incur any extra costsforincreased materials or labor costs. However, contractors and project owners must track costsand supervise the project carefully to ensure fair payment, requiring more burdensomepaperwork and oversight.
Lump Sum vs. Time and Materials Contracts
Time and materials (T&M) contracts stipulate that the owner provides reimbursem*nt formaterials and a daily or weekly payment for labor costs. Like cost-plus contracts, time andmaterials contracts work well with project specifications and scopes that are stillambiguous as the project starts.
T&M contracts provide contractors with a daily or weekly rate, providing a steady income.Project owners benefit from the adaptability of these agreements, ensuring that the workoccurs to specification.
Time and materials contracts require additional paperwork compared to lump sum contractsbecause labor costs must be recorded accurately.
Lump Sum vs. Unit Price Contracts
For unit price contracts, the price is based on the estimated per-unit cost of the materialsand is divided into stages, usually by construction trade (e.g., carpentry, electric,plumbing and more). For this reason, unit price contracts are standard in subcontractingagreements. Many painting contracts, for example, follow a unit-price structure as paintingis generally charged on a square-foot basis.
As with cost-plus and T&M contracts, unit price contracts benefit project owners whenthey have a general idea of the project that needs to be done, but the concrete planningisn’t completed. For example, you may establish a per-square-foot price for flooringandinstallation, even though you don’t know exactly how many square feet of flooringyou’llneed covered. Because you know approximately how much materials and labor would cost, youcan establish a unit price for this and other aspects of a construction project. Contractorscan get a handle on good approximations of costs and revenue from each stage. Both ownersand contractors can adapt the project as necessary without having to submit change ordersand renegotiate prices, as they would have to do with a lump sum contract.
Anotable shortcoming is that there is a significant risk of cost overrun since thesecontracts usually lack a unit threshold.
Lump Sum vs. Guaranteed Maximum Price Contracts
A guaranteed maximum price contract (GMP), also known as a not-to-exceed price contract,requires owners to compensate contractors for their direct costs as well as a fixed fee foroverhead and profit — but only to a certain threshold. The contractor is responsibleforadditional costs once reaching this amount. The maximum price can be increased via a changeorder if the project’s scope changes, but not for errors or cost overruns.
Remember, with lump sum contracts, whether or not the project actually cost the estimatedamount, the contractor gets the same amount. That is not the case with maximum pricecontracts and the owner, not the contractor, will keep cost savings if things come in underbudget. In some cases, the owner can share a portion of any savings with the contractor toencourage timely work and keep costs low.
These contracts are suitable for owners who have a tight budget as there is an absolute upperlimit. For contractors, however, GMP contracts increase their financial risk if costs exceedthe limit.
When Would You Use a Lump Sum Contract?
Lump sum contracts are standard in construction projects, but they aren’t suitable foreverysituation. These contracts work best for projects with finalized plans, clearly definedscopes and schedules and proper documentation of all assessments and other pre-constructionactivities. These aspects are crucial to allow the contractor to estimate project costs andprovide the lump-sum amount accurately.
These agreements are best suited for simple projects with subcontractors, specific parametersand a low risk of unforeseen problems.
When all of these elements align, lump sum contracts provide an uncomplicated agreement thatboth project owners and contractors can easily understand and agree on. But what are theadvantages and disadvantages of a lump sum contract? Advantages for owners includesimplified accounting and little financial risk, and disadvantages include rigidity inproject scope and a need to have every detail planned before beginning the project.Advantages for contractors include clear directions, less paperwork and a potential forprofit if the project comes in well under budget, and disadvantages include risk if theproject is more costly than expected.
Advantages of Lump Sum Contracts
The simplicity of lump sum contracts provides benefits for both owners and contractors.
Advantages for project owners
The predictability of lump sum contracts is the primary benefit to project owners. The ownercan expect the project to be completed within budget and often more quickly so that thecontractor can maximize resources and save on labor costs. Lump sum contracts also renderlittle financial risk for owners as the contractor is responsible for any cost overruns.These factors make it easier for project owners to obtain financing since lenders prefer tofund defined projects with clearly delineated costs.
Owner supervision of lump-sum contracts is minimal as the owner does not need to track costs.Also, the payment structure of lump sum contracts usually comprises regular payments atspecific iterations or as a percentage of the work that has been completed, simplifyingaccounts payable processes.
Advantages for contractors
Despite the increased financial risk of lump sum contracts compared to some other types ofa*greements, contractors still receive many benefits.
Under a lump sum agreement, project owners must provide contractors with finalized plans andthorough documentation, resulting in specific, linear project tasks. Lump sum contracts alsorequire less paperwork, management and accounting, decreasing administrative costs.
Another advantage of lump sum contracts is that they do not require contractors to disclosehow they calculated their materials or labor costs, allowing them to provide estimates withsufficient cushion to avoid going over budget. If the project is under budget, thecontractor keeps the profit.
Disadvantages of Lump Sum Contracts
Lump sum contracts can have downsides for owners and contractors, as well.
Disadvantages for project owners
Owners must submit and adhere to completed designs and finalized plans, making the projectinflexible. If a change is needed, lump sum contracts stipulate the use of a formal changeorder process and a considerable amount of paperwork.
There is also the risk of being charged a higher amount to cover the contractor costs forunforeseen situations. Similarly, contractors could use inferior materials or otherwise cutcosts to increase their profit from the fixed price. That’s why it’s prudent forowners tospecify materials in the pre-construction documentation they provide to the contractor.
Disadvantages for contractors
Contractors incur the cost of going over budget, which can eat into profits. Contractors alsoshare the disadvantage of time-consuming change order paperwork if modifications need tooccur.
Variations in Lump Sum Contracts
Variations are prevalent triggers of disputes in construction projects. With lump sumcontracts, any change in the plan, scope or costs is considered a variation. The most commoncauses of variations include:
- Design errors, omissions and discrepancies
- Incorrect interpretation of plans or designs
- Specification changes
- Increases or decreases in necessary material quantities
There are two types of variations. Beneficial variations reduce or eliminate costs, shortenthe schedule or otherwise improve the project, which can be a boon to owners andcontractors. Detrimental variations negatively affect costs, time and other aspects of theproject, such as discovering an unexpected water main which results in an overhaul of theoriginal construction plans.
In either case, some variations require a formal change order request from either the owneror the contractor. Change orders must include four key points:
- A comprehensive description of the requested modification
- A credible justification of the change
- An estimation of the costs of the proposed change
- An explanation of the impact that the proposed change could have on the projectcompletion date
Modifications cannot occur unless all parties agree to the new terms. That often requiresnegotiations that can go on for some time, halting work.
Lump sum contracts are designed to reduce variations significantly, but they can still occurif there are overlooked details or unforeseen circ*mstances. Ensuring that all materials areavailable, the design and plan are accurate and that everyone fully understands the projectcan further protect project owners and contractors from time- and money-consumingvariations.
Common Issues With Lump Sum Contracts
While lump sum contracts are straightforward and reduce many common construction contractheadaches, they are not without issues that can have varying impacts on project owners andcontractors.
Delays
Delays are often consequences of unforeseen circ*mstances out of either party’scontrol, suchas weather or supply chain disruptions. Other times, a lack of clarity, failure to providetimely instructions, inadequate labor or a lack of equipment or materials is to blame.
Lump sum contracts should include provisions that stipulate the circ*mstances under whicheach party would be responsible for delays and the associated costs. That can reduce therisk of contract breaches as well as the need for time-consuming and costly litigation.
Cost fluctuations
The price of labor and materials can be fluid and subject to change throughout the project.Lump sum contracts generally do not account for these fluctuations, so contractors have toabsorb the cost if prices rise. However, they can also realize savings if rates go down.These risks are arguably more pronounced in extended projects.
Contractors must factor in possible upward fluctuations and price the project accordinglywhen providing the estimate.
Provisional sums
Although lump sum contracts are pretty iron-clad as far as scope and cost, provisional orstipulated sums refer to the price of optional project work. The provisional sum is includedas a separate estimate within the contract and only changes if the owner decides it’sa goodidea to move forward with the elective work.
The work associated with stipulated sums can cause issues with the project schedule,primarily if implemented later in the project. It can also lead to modifications thatrequire formal change orders. That’s why it’s essential that the terms of a lumpsum detailhow to handle provisional sums and the limits of any related changes.
Lump Sum Contract Construction Example
It’s essential to develop a lump sum contract correctly and fulfill it to the letter.Butwhat is a lump sum contract in construction? It’s one kind of construction contractwhere asingle price is used for an entire project. The estimated cost is developed after thecontractor understands all the details of the construction project, includingspecifications, materials and timelines. Proper creation and execution of a lump sumcontract for a construction project look something like this:
A project owner needs to build a storage shed to increase inventory space, so he approaches acontractor for the job. The owner has already completed the building design and constructionplan, performed the necessary surveys and received the required permits. In the constructionplan, the project owner also notes that he would like to use a particular cement brand.
The contractor evaluates the documentation and calculates how much the labor and materialswill cost. She takes the pricier cement that the owner requested into account and includes abuffer amount to allow for unanticipated expenses. She then adds another amount to coveroverhead and profit to the final project estimate.
The project owner agrees to theprice, and the lump sum contract:
- Adequately lays out the scope of the project
- Contains robust project modification controls
- States a price that includes all costs related to the project
- Details who is responsible for various additional costs
- Delineates provisional sums and the associated work
- Includes the estimated completion date
Both parties agree to the contract’s terms. The work, which should take six months,begins.The owner pays one-sixth of the fee every month.
Halfway through the project, the project owner decides to install tile flooring over theconcrete. That is outside of the original agreement’s scope, so the owner submits aformalchange order that the contractor reviews and then provides a new estimate for the project.The project owner agrees, and work continues. Installing the tile pushes the estimatedcompletion date out by two weeks and increases labor costs for the contractor, but theadditional amount that was agreed to via change order protects the contractor’sprofits.
When the project is complete, the contractor managed to come in under budget, providing herwith additional profits.
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Managing risks, variations and other lump sum contract issues is seamless with the rightaccounting software. Accounting software can improve all aspects of accrual basis job costaccounting, including billing, bookkeeping and financial reporting. It can automatecost calculations, perform payroll tasks and keep track of payables and receivables.Single-entry functionality can also eliminate some manual data entry.
Accounting software forconstruction projects often includes job cost modules to track project-relatedpurchases, labor costs and overhead. This kind of accounting software can also track detailsdown to project tasks and be applied to contracts, allowing contractors to track theoriginal lump sum contract amounts and any change order amounts. It’s also possible toputcontrols into place that establish a threshold for costs to ensure that the project stayswithin budget.
While they are one of the least complicated types of construction contracts and have a myriadof benefits for both owners and contractors, lump sum contracts still require carefulconsideration and execution. Utilizing capable technology is imperative so lump sumcontracts perform as intended. Financial managementsoftware can help contractors expedite contract processes across the board, fromdeveloping an estimate to implementing modifications to processing final payments.
