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 which sets a total established price upfront for all construction-related activities undertaken during the lifetime of the project. Fixed price contracts 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.
A fixed price contract sets a total price for all construction-related activities during a project. Many fixed price contracts include benefits for early termination and penalties for a late termination to give the contractors incentives to ensure the project is completed 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. Because of this, many contractors will give themselves some leeway for unexpected costs to occur, 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 seen as favorable in the construction industry because of its simplicity–there is usually much less administrative oversight and paperwork to complete.
There are many benefits to using a fixed-price contract in construction. One of the main reasons it is so common to use is because of its simplicity–companies are willing to pay a higher price tag up front to avoid dealing with open-ended hourly or daily billing contracts and material costs. Both the company and the contractor know the exact cost of the commercial construction upfront which is an incentive for contractors to ensure accuracy during the bidding process.
Because contractors are able to put a price tag on the project as a whole, it allows companies to avoid being caught up in tedious details and gives the contractor more freedom on 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 mark up added to the price by the contractor.
However, there are also several potential downsides to using a fixed-price contract in commercial construction. Chiefly, it can be very 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. Because of this, many fixed price contracts are priced slightly above market value.
Additionally, there is also 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 in order to maximize their profit, but conflicting visions between the contractor and company could lead to disagreements over scope. Therefore, it is extremely important to have a clearly defined scope before agreeing to a fixed-price contract.
Other Types Of Contracts
While fixed-price contracts are widely used in construction, there are a few other types of contracts that are prevalent within the industry. Cost-plus contracts are an alternative type of contract which calculates the payment of actual costs, purchases, and other expenses that come directly from any activity surrounding the construction project. In a cost-plus contract, there is typically a predetermined price which includes the contractor’s overhead costs and expected profit from the project. These type of contracts are useful in projects where the scope is not clearly defined, as it is the responsibility of the owner to establish the scope and price of the project.
Another type of contract used in the construction industry is a time and material contract, which establishes an agreed rate (usually hourly or daily) and includes additional expenses that arise during the life of the project. Finally, unit pricing contracts are a type of contract commonly used in federal agencies which set a price during the bidding process for a predetermined amount of items used and contractors are paid by unit price.
Fixed-price contracts are extremely useful to the construction industry because of their straightforward nature and widespread use. It is important to consider the benefits and drawbacks of a fixed-price contract and to clearly define the budget and scope with the contractor before proceeding with the contract. When implemented properly, fixed-price contracts are an effective tool to minimize complications and streamline the collaboration in construction projects between the company and contractor.