Home » Types of Construction Contracts: Cost vs Risk

Types of Construction Contracts: Cost vs Risk

By Reese Freeman

Published March 30, 2022

Updated 4 months ago

What am I getting by hiring a general contractor? Quality assurance, a reliable network, project management, and money management are some of the responsibilities that come to mind. Hopefully, that takes some of the daunting tasks off your plate and is worth the cost of a general contractor. But how much is that going to cost, and what is it worth? Here is a list of the types of construction contracts that will help answer that question.

How a General Contracting Business makes Money

Objectives in the contracting business are achieved through construction contracts and the competition of the scopes of work outlined within them. Within each construction contract between a general contractor and their client is some form of an offer to be agreed to as compensation for the direct costs and indirect costs incurred as the contractor acquires services, goods, and personnel for the project. This compensation is often referred to as a percentage, fee, or markup and is typically some sum of money that is more than the direct costs of the project. As a part of that sum of money, the contractor, just like every private business, is entitled to a profit and that is how general contractors make their money.

Total Project Cost = Reimbursement of Direct Overhead Expenses + GC Compensation (i.e. Indirect Overhead Costs + Profit)

Profit Margin

There is only one way to stay in business and that is to maintain a profit margin. General contractors benefit from profits and share those gains by enhancing their capabilities to better deliver a service and product to their clients. With profit, the construction business can attract talent, be better equipped, grow in market share, innovate, and expand to offer more competitive pricing. If the general contractor is good, they will enjoy these fruits of their labor and ultimately share this economic value and experience with their clients and the greater community.

Profit = Total Project Cost – (Direct + Indirect Overhead)

Overhead Costs

The percentage, that is the additional sum of money paid to the general contractor on top of the project cost, will cover the business expenses that are not charged directly to the project. These expenses are considered to be “indirect” overhead and can include but are not limited to labor costs for salaries unrelated to project costs such as owner’s and office staff, equipment maintenance, office supplies, rent, and insurance. These are simply the costs to be in business, and even as every business attempts to offset these costs, no business can completely escape overhead.


Types of Construction Contracts and Compensation Structures

There are many variations of contract compensation and small nuances that go into them, so it is always important to read and understand a contact’s terms and conditions. Here are the basic compensation structures in the construction industry that outline what is found in most construction contacts.

Time and Materials Contracts

Time and materials contracts generally break line items down into two categories, the amount of time worked on a per time basis and the material costs of the project. This contract is simple and is best suited for projects with many unknowns and simpler projects. The contractor is compensated by marking up materials and labor. In a similar scenario, this contract can be easily made into a unit price contract which measures each unit of materials and labor yet includes profit and overhead as separate line items. Unit price contracts and time and material contracts are very common but certain precautions should be taken to ensure that work is being done efficiently and is measured correctly.

Cost Plus Contracts

Depending on the local market, general contractors will be compensated a range of a percentage of the total project cost; hence, cost plus a percentage.

In the town of Steamboat Springs, CO the range of the markup percentage is currently between 10% – 20% for a custom residential home project or remodel.

This percentage should address the general contractor’s proportionate indirect costs in the project and a profit. One caveat to cost plus contracts is that if the cost of materials go up then the general contractor makes more off of the percentage. Cost plus contracts are often best in situations where the scope of work is moderately defined and is a very common contract for the construction of new homes and remodeling projects because there are often a myriad of changes that can take place.

Fixed Fee

This contract is another form of the cost plus contract that takes the percentage and translates it into a monetary value to be paid periodically on the agreed upon payment terms. See the table below for reference. This minor change can have some pretty big benefits for a client. One being that if the direct cost increases, say from inflation, the money that the general contractor makes will not change. Also, if the general contractor is able to provide a schedule, and agrees to particular contract terms that are consequential to that schedule, then the general contractor has an incentive to finish the project on time. Since the general contractor is taking on more risk with this contract, they will likely put in a lot of time during pre construction to understand the scope of work and reference that scope of work in the contract. Any changes to that scope of work will be handled via a change order and adjustments to the fee will be made accordingly. This type of contract is suitable for qualified contractors and projects with well defined scopes of work.

Direct Cost Timeline Cost-Plus Fixed-Fee Monthly Fee Total Cost
$1,000,000 10 months 10% $80,000 $8,000 $1,080,000
$1,000,000 10 months 15% $150,000 $15,000 $1,150,000
$1,000,000 10 months 20% $200,000 $20,000 $1,200,000

Fixed Price

This construction contract is one lump sum of money to complete the work. Also known as a lump sum contract, it rids the construction contract of the general contractor’s cut as a line item by including it in the total sum of the contract. General contractor’s will often have their profit and overhead added into the total cost by spreading out the markup amount of the line items or defer from including any line pricing information completely. From a client’s perspective, it is nice to see just one price for a scope of work; however, there are often more assumptions to this contract. A general contractor may submit a proposal with a higher number to ensure that they are covered by any of those assumptions, which means that the client may end up paying more. On the other hand, the contractor may end up losing money on the contract if they run into problems, which is especially likely when they do not fully understand the scope of work. Changes are handled through change orders and adjustments are made as necessary. Experience, and knowing the scope of work are imperative under this contract for both parties in fixed price, lump sum contracts.

Levels of Risk

Construction contracts have a corresponding level of risk-reward for both the general contractor and client, this is assuming that the scope of work is well defined through the client-general contractor relationship. Take a look at which type of contract is the riskiest to the client vs the contractor:

Contract Client Risk Contractor Risk
Time and Materials High Low
Cost-Plus High Low
Fixed Fee Medium Medium
Fixed Price Low High

Things to Consider

General contractor’s are essential for successful projects. Quality assurance, a reliable network, project management, and money management are their primary services and it is important to remember that without this, you will be easily taking on a part time job. In a world where mistakes can have massive consequences, it is generally safer to stick with someone who is an expert. Here are a few things to watch out for when reviewing a proposal.

Double Dipping

Some line items, such as labor, are marked up to cover “burdened expenses”. If a general contractor is providing labor or materials that contain associated costs such as project management or payroll taxes and benefits, then that cost will be included into the line items total onto the client. Since making a profit is a part of the general contractor’s compensation, making profit off of these costs is a red flag. If some “padding” is added to that burdened rate, that is understandable, but excessive margins above 10% are questionable unless they are operating those expenses under a separate business. In the case of project management, contractors may provide a separate line item for this expense.

Indirect Overhead

As a client, you should ask “how does this line item benefit the project”. Items like heavy equipment, though provided by a general contractor, are still essential to a project and are therefore considered a direct cost to the project. A line item such as “General Liability Insurance” only benefits the general contractor and is essential for staying in business and should be considered an indirect cost. Look out for line items that you feel are not benefiting your project.

Under Defined Scopes of Work

Having a defined scope of work for a project will make being a client easier. The upfront cost associated with defining that scope of work will help both parties involved because you will have a better understanding of what is being agreed upon in the contract and the contractor will be able to more accurately estimate costs. This gives a baseline understanding of what work orders are to be performed by each contractor and on what grounds change orders should be issued upon. If a contractor is unable to provide a display in understanding of the scope of work, to the second or third degree, then that is a red flag. The upfront cost will be well worth the insurance to prevent excessive problems, hiccups, surprises, and other costs that were unanticipated in the final cost.

In the event where you may be unsure if the scope of work is fully defined, consider discussing a guaranteed maximum price (GMP) as a part of your contract terms. This clause in the contract will set a cap on the amount the general contractor can bill for. This way, you can gauge the contractor’s confidence in their understanding of the project while feeling more secure about the amount of money that will be spent.

Conclusion

At some point, electing to hire a general contractor will be beneficial to the project. Once more than three trades become involved with a project, it is the wise decision to call in an expert to ensure quality assurance, provide a reliable network, manage the project, and manage the money. Hopefully, this article will provide you with some insight into how a general contractor is paid, what that might cost, how to choose from the types of construction contracts, and what to look out for when reviewing the proposal. If you are looking for a general contractor in the Steamboat Springs area, please reach out to Steamboat Springs Construction Co. we would be happy to assist you and build your future home!

By Reese Freeman

By Reese Freeman

I have a penchant for systems thinking and a methodical approach to how I manage projects and organizations. Education is a pillar of my career in construction and I will continue to pursue new knowledge to leverage improvements in myself, projects and organizations. My motivation is simple. I believe that beautiful spaces enhance the prospect of peace.