What’s a Fixed Price Contract in Construction?

Establishing a pricing method is an essential part of the pre-construction stage of a project. Generally, contractors choose to use either a fixed-price contract or a contract with dynamic pricing. 

A fixed-price contract in construction is a pricing method that sets a total established price upfront for all construction-related activities undertaken during the project’s lifetime. These are sometimes referred to as lump sum contracts and are usually seen as favorable in the construction industry when there is a clear scope and defined schedule for the project.

Many fixed-price contracts include benefits for early termination and penalties for late termination. This incentivizes contractors to complete the project on time and within scope.  

Typically, the contractor will estimate total labor and material costs and complete the project for the set price, regardless of the actual cost. Due to this, many contractors will give themselves some leeway for unexpected costs and expenses, meaning that the customer may be paying slightly above market price for the job.

This price also reflects the risk the contractor is assuming by agreeing to a fixed price contract, but some contractors will offset this risk by giving a quote range rather than a specific price. However, using a fixed-price contract is still favorable in the construction industry because of its simplicity. There is usually much less administrative oversight and paperwork to complete.

Fixed-Price Contract Advantages

There are many advantages to using a fixed-price contract in construction. One of the main reasons it is so common is its simplicity. Companies are willing to pay a higher price upfront to avoid dealing with open-ended hourly or daily billing contracts and material costs. 

Since both the company and the contractor know the exact cost of commercial construction, the information incentivizes contractors to ensure accuracy during the bidding process.

Another fixed-price contract advantage is that contractors can put a price tag on the project as a whole. This lets companies avoid being caught up in tedious details, giving the contractor more freedom in day-to-day activities. 

To many companies, the potential increase in total customers and revenue due to the simplicity of estimating fixed-price contracts upfront outweighs the markup added to the price by the contractor.

Fixed-Price Contract Disadvantages

There are also several potential disadvantages of using a fixed-price contract in commercial construction. For example, it can be difficult to make an accurate estimation upfront, so many contractors give themselves financial leeway to plan for any unexpected costs and ensure they are turning enough profit for the investment they are making. This often ends up with fixed-price contracts that are priced above market value. 

In another example, there is a risk that a contractor may pad their profit by skimping on cheap workmanship or materials. The contractor wants to finish the project on time and within budget to maximize profit, but conflicting visions between the contractor and the company could lead to disagreements over scope. Therefore, having a clearly defined scope before agreeing to a fixed-price contract becomes important.

Types of Fixed-Price Construction Contracts

Since every construction project is unique with different sets of objectives and expectations, their contracts can be adjusted based on the scope. Hence, contractors can choose from different types of fixed-price contracts. These are also recognized by local regulation bodies.

Firm Fixed-Price Contracts: These contracts are rigid with little to no room for negotiations. Contractors have no choice but to agree on the stated price regardless of the profit/loss potential.

Fixed-Price Incentive Contracts: These contracts keep the project’s cost and target price as close to each other as possible for a higher profit percentage.

Fixed-Price Contracts With Economic Price Adjustment: These contracts give contractors flexibility to adjust the price based on external factors. The safety net is helpful in uncertain markets where the price of goods can suddenly escalate during construction.

Fixed Ceiling Price Contracts With Price Redetermination: These contracts also give a safety net but within a set period. Contractors can either adjust pricing at specific times during construction or after the project is complete. In both cases, the ceiling (highest) price is determined before the project begins.

Firm Fixed-Price Level-of-Effort Contracts: These contracts are rare to see these days due to their unfavorable conditions for contractors. The contracts allow price adjustments based on performance metrics within a set period.

Types of Contracts Other Than Fixed Price

While fixed-price contracts are widely used in construction, a few other types of contracts are prevalent within the industry. 

Cost-plus contracts, for example, calculate the payment of actual costs, purchases, and other expenses that come directly from any activity surrounding the construction project. The predetermined price often includes the contractor’s overhead construction costs and expected profit from the project. Such construction contracts are useful in projects where the scope is not clearly defined as it is the owner’s responsibility to establish the project’s scope and price.

Cost-reimbursement contracts contain a ceiling price that the contractor should not exceed without approval. This price is set based on an estimated final total cost once the construction project is completed. The buyer will then pay any incurred costs detailed in the contract.

Time and material contracts, as another example, establish an agreed rate (usually hourly or daily) and include additional expenses that arise during the project’s lifetime. 

Finally, unit pricing contracts are a contract type that is commonly used in federal agencies. They set a price during the bidding process for a predetermined amount of items used and contractors are paid by unit price.

Conclusion

Fixed-price construction contracts offer numerous advantages for both contractors and owners. Their straightforward nature provides safety nets for all parties involved that mitigate risk and uncertainty. 

With a price already established beforehand and a budget in clear sight, contractors can make use of the clear scope of work to complete the project within the timeline while fully knowing all the financial risks and challenges involved.

When implemented properly, fixed-price contracts are effective tools to minimize complications and streamline the collaboration in construction projects between the company and contractor.