Construction Contracts Explained – Choosing the Right One for Your Business

Starting your own construction business comes with a lot of learning – and not just the skills you bring as a builder or remodeler. 

Running a successful construction company requires you to make a lot of correct decisions before your work even begins: on everything from choosing the right marketing approach for your business to choosing the right projects for your team. And to add to the complexity, choices that might be right for some businesses, aren’t always right for others.

So how do you navigate these uncertain waters to come out on top?  

Well, this article can’t teach you how to run your business but it will shed some light on one very important factor…  

Construction Contracts.

Contracts are designed to protect both parties and spell out what’s expected from all those involved. As custom home builders and remodelers, you know the importance of having a signed contract. But, it’s just as important to choose the right type of contract for your business. 

The most popular contracts used in the construction industry are the fixed-fee contract, cost-plus management fee contract, and cost-plus percentage contract. These all have their pros and cons and there’s a lot to consider, so let’s dive in.

Protip: Our free construction invoice template auto-generates ready-to-print invoices for each of the contract types for you to easily choose from. Download it for free.

The Fixed-Fee Contract

Fixed-fee contracts are exactly as they sound: “fixed” aka an exact amount. The project is done at a set price despite any unforeseen challenges, making the fixed-free contract the riskiest contract type for contractors or subcontractors. However, this works both ways, so if your job goes better than expected, you reap the benefits and make a higher profit. 

Keep in mind that your estimating skills should also be stellar if you're opting for a fixed-fee contract. Because if you somehow forget to cover minor things like drywall screws, guess what? You get to eat those costs. You can also end up with additional costs related to delays or mistakes. 

To avoid paying for these oversights keep these things in mind:

• Always get detailed information from your client like specifications, blueprints, etc. Remember, it’s better to have access to information and not need it than to wish you’d asked for more ahead of time.
• Protect yourself against uncontrollable problems, like weather delays, by building that into your contract.
• Be thorough about the scope of work to avoid any discrepancies about what is and isn’t included.
• Include a detailed payment schedule in the contract so the client knows when payments are expected.
  

Fixed-fee contracts can be scary, but with experience, they’re also the most straightforward and can benefit both your company and your clients.

The Cost-Plus (Management) Fee Contract

If a home builder or remodeler wants a little more flexibility and less risk, then the cost-plus management fee contract might be a good fit. In the cost-plus management fee contract, the client agrees to pay for all the job expenses plus a set fee to cover the contractor's expenses. This isn’t the only type of contract that’s in the cost-plus category, but it is one of the more widely used contracts for residential construction projects.

Cost-plus management fee contracts are most often used when estimating is difficult because of unknown factors, like lumber price increases or unknown site conditions. It’s more favorable to the builder or remodeler because their fee is set no matter what problems might arise. 

It also allows the client some control over what is spent, which can pose some difficulty for the contractor. But overall, it’s not a bad deal for the contractor.

Here are a few points to consider:

• Clearly spell out exactly what the expenses are and how they’re calculated.
• Specify costs in the contract. Be specific with costs like project managers or employees if you’re adding your indirect costs and overhead. These are most often not included in the contractor fee. 
• State if change orders result in management fee increases or additional overhead. Also, specify when these should be paid so they don't pile up until the end of the job.
• Have a detailed payment schedule so any direct expenses during the job can be reimbursed promptly.
  

The cost-plus management fee contract might be contractor-friendly, but it can also be tricky. It’s important to spell out what the terms are and when the builder or remodeler needs to get paid.  

The Cost-Plus % Contract

Cost-plus contracts are all pretty similar and have a lot of the same pros and cons. In the cost-plus percentage contract, the client agrees to pay the contractor for all their expenses plus an agreed-upon percentage of profit. 

This is by far the most popular of the cost-plus contracts and is used a lot when there’s a risk that costs could significantly change. It allows the contractor’s profit to automatically fluctuate when the contract price fluctuates. Most clients like this type of contract because it goes both ways, with an increase or decrease in the contract amount, the profit also changes.

However, this type of contract does require a more hands-on client because almost every expense must be approved. So you can imagine that there will likely be some issues and delays in the process. But the good news? The overall majority of the financial risk falls on the client. 

The downside of this structure for the client is that they pay more to the contractor if they decide to upgrade their materials (light fixtures, plumbing fixtures, hardwood floors, etc) when there is no real additional effort for the contractor.

This can be a frustration for the client, so managing this part of the process for the contractor is important. Maybe consider "excluding" or making "fixed" certain items from the cost-plus.

In this scenario, good communication is key and the contractor might want to consider streamlining the process.

A few important tips:

• Specify any costs in the contract that are not covered by the percentage, like if you’re adding in your project manager as a separate expense.
• Be sure all expenses are documented and that proof of expenses are provided to the client.
• Change orders should still be used and the client should sign off on each one, like in any contract.
• Have a detailed payment schedule to make sure that the client is aware of when reimbursement is expected since the contractor will be paying for the expenses during the project. Be sure to check with your state’s licensing board to stay in compliance with any rules on when and how much you can collect.
  

With the cost-plus percentage contract, you’re protected from eating the cost of unpredicted changes, however, it requires more approvals from the client and more back-and-forth. So, consider all aspects before deciding to go with this type of contract. 

Getting Your Construction Contract Right the First Time

Whether you choose to use a fixed-fee contract or a cost-plus contract, some things remain the same:

• All contracts should be as thorough as possible
• The scope of work should be clear
• The process for managing Change Orders should be clearly documented in the contract. When changes arise, Change Orders should be specific, signed off on before work is performed, and paid in full when executed so that you aren’t stuck trying to collect those payments at the end of the job.
• Include a detailed payment schedule and be sure to check with your licensing board for rules
  

A home builder or remodeler should only use a fixed-fee contract if you have superior estimating skills – or else you’ll probably lose money. This contract is the riskiest, so most builders and remodelers will shy away from using it unless necessary. However, it’s one of the more favored contracts for subcontractors because the scope of work is usually narrow and specific, so it’s easier to be accurate in estimating.

The more contractor-friendly contracts are the cost-plus contracts. Whether it’s a flat management fee or a percentage, the client agrees to reimburse for all expenses plus either a set amount or a percentage of all costs. These contracts are often used when budgets are tight or costs could greatly vary. Most contractors prefer these types of contracts because it minimizes their financial risk. In these types of contracts, it’s important to keep track of ALL expenses and make sure to get your client to sign off as you go.

Pro Tip: Using a construction management tool like BuildBook will save you both time and stress during projects by giving you a single place to stay on top of your contracts, project schedule, tasks, budget, client approvals and much more.

We hope this helps you to better understand and decide which contract is right for your construction company. But no matter what, do your research and become a pro at estimating. Once that’s out of the way, you can do what you do best and create happy clients!