Contract Pricing Structures
There are various price structures for construction contracts. It is important for owners and contractors to understand how each structure allocates risk and carries potential reward.
Lump Sum/Fixed Price.
Lump sum/fixed price contracts set a firm, fixed contract price. The contractor submits a bid or proposal offering to perform the scope of work for a set price. If the owner/client accepts that price, that is the amount that the contractor is entitled to receive for its work on the project. This is the most common price structure. For instance, the AIA standard subcontract (AIA Document A401-207 Standard Form of Agreement Between Contractor and Subcontractor) dictates a fixed "Subcontract Sum." The contract price can only be adjusted through a change order. More on that here.
The owner/client benefits from this price structure through certainty and minimization of risk. For instance, if there are substantial price increases (say, from a pandemic, worldwide supply chain constraints, etc.), the contractor must absorb these additional costs. (Unless the contract provides relief through, for example, a force majeure provision. More on that here.) The contractor bears most of the risk. But it also reaps any rewards. If there are price decreases or, more often, the contractor is able to complete the work more efficiently than anticipated, the contractor keeps the additional profit. This profit motive incentives the contractor to complete the work as quickly and efficiently as possible.
In a cost plus contract, instead of a fixed price, the parties agree that the contractor will be paid the actual cost of the project plus a certain percentage for overhead and profit. Typically the contractor will provide an estimate of the anticipated project costs. But it is just that - an estimate. The price of the contract is the amount of the actual costs plus the agreed upon percentage.
With this structure, the allocation of risks and benefits reverses. The owner/client assumes all risks of price increases. But that party reaps the rewards if the project comes in at a lower cost. The contractor, on the other hand, bears no risk. Further, the contractor's incentives reverse as well. There is no longer a profit motive to incentivize the contractor to complete the work as quickly and efficiently as possible. Instead, as costs increase, the contractor's price increases.
Time and Materials.
In a time and materials price structure, the parties agree to base the contractor's compensation on hourly rates and material costs. The largest benefit of this structure is flexibility. There is no need for the contractor to scrutinize the proposed scope of work or schedule for the project to provide a comprehensive bid. Work can commence immediately. For this reason, this price structure if favored for smaller, discreet scopes of work that need to be performed quickly. There is also no need for change orders. The owner can simply direct the contractor to perform any scope of work and quickly receive an invoice.
The drawbacks of this structure include increased risk and budgetary oversight. As with cost plus contracts, the lack of a fixed or not-to-exceed price shifts the risk of cost increases and delays to the owner/client. Again, the contractor has no incentive to complete the work as efficiently and inexpensively as possible. The longer the project, the higher the price the contractor receives. For this reason, the owner/client will often have to audit the contractor's time and direct costs to ensure that the work is being performed efficiently.