There are different types of construction contracts and each is viewed differently by contract surety bond underwriters. Understanding the risks associated with each is important of the successful completion of any project.
Fixed Price (Lump Sum) Contract
A Fixed Price Contract or Lump Sum Contract is the most common type of construction contract. Under a Fixed Price Contract, a contractor estimates the costs to complete the project and then adds markup for the contractor’s overhead and profit. The contractor then submits the bid to the owner directly or through a bid letting. The Owner expects to pay the fixed amount to complete the project and no more. The contractor under a fixed price contract is expected to bear the risk and reward of constructing the project. If the costs are more than the estimates, the contractor will make less profit than anticipated or even lose money. If the costs are less, the contractor could recognize additional profits. Estimating construction projects is difficult. Contractors must often predict the future of weather, labor markets and material prices. This can lead to significant risk and losses that cannot be passed back to the Owner under a Lump Sum Contract.
Fixed Price Contracts are also the most disputed type of construction contract as the expectations of Owners and Contractors are often very different. Poor designs, vague specifications and contracts can all lead to disagreements. Additionally, under a Fixed Price Contract, any changes to the contract are expected to be addresses through proper change orders which are agreed to and signed by both parties. However, this is frequently a cause of disputes and even contractor failure. Contractors who are often excited for additional profit, perform the work and incur the cost before the change orders are signed. Unapproved change orders often lead to losses for the contractor.
Contract Surety Bonds and Fixed Price Contracts
To ensure a contractor completes the project for a specified price, Owners often require performance bonds and payments bonds from the contractor on fixed price contracts. The performance and payment bonds provide a third-party guarantee to ensure that the project will be completed according to the contract and agree price and that subcontractors and material suppliers will be paid. Even though they present more risk, Surety Bond Companies like Fixed Price Contracts. They can accurately estimate their maximum risk on each project and provide surety credit accordingly. Just as important, surety bond companies have many years of experience handling fixed price contracts and case laws are very established for these contracts. Other lenders often like fixed price contracts as well. It can make getting project financing easier. Owners often like lump sum contracts as they know their maximum cost upfront. However, fixed price contracts can be very risky to contractors. In fact, many large contractors have gotten out of the fixed price contract market after large losses. Lump sum contracts are most appropriate for projects that are well defined.
Unit Price Contracts
Unit Price Contracts are broken out by trade or section. A contractor provides the Owner a price for specific quantities of work. Examples include pricing utility lines by the linear foot or excavating soil and rock by the cubic yard. The final contract price is determined by the amount of work performed. Unit price contracts are appropriate when the quantity of work is hard to estimate up front. On the other hand, unit price contracts are rarely used for buildings and structures. Unit Price Contracts make it easy for Owners and Contractors to start projects with routine tasks.
Contract Surety Bonds and Unit Price Contracts
Surety bond underwriters look favorably at unit priced contracts. If the contractor’s estimates are good, they can significantly reduce the default risk for the contractor and surety bond company. They also allow both Owners and surety bond underwriters to benchmark the Contractors bid price with industry standards. These standard are published yearly by many reputable companies. Some contractors assume that there in no risk to Unit Price Contracts. Unfortunately, that is not true. Fuel, labor, material, and weather are still unpredictable. Additionally, Owner abuse could be a problem in Unit Priced Contracts if the quantity of work significantly exceeds the expected scope. Many contracts limit the quantities to a percentage above the estimate such as twenty percent. A bad unit price can add up to losses for a contractor and their surety bond company as quickly as a fixed price contract.
Cost Plus Contracts
Costs Plus Contracts are an agreement where the Owner agrees to reimburse the Contractor for certain contract expenses PLUS a fee for the contractor’s overhead and profit. The fee can be a percentage of the contract or a fixed fee, which is more common. Usually the Contractor still gives the Owner an estimate of the project up front. Then as work is performed, the Contractor submits approved costs for reimbursement by the Owner. It is very important in Cost Plus Contracts to define what is reimbursable by the Owner. Common items are Performance and Payment Bonds, job materials, subcontract costs, building permits, equipment, etc. However, it is important to negotiate the Contractor’s costs as this can be a point of contention. Examples include the Contractor’s supervision, use of Contractor’s owned equipment, vehicles, insurance, etc. Are these project costs or part of the Contractor’s overhead? These things should be negotiated up front to avoid disputes.
Guaranteed Maximum Price
One of the biggest risks to Owners in a Cost-Plus Contractor is that there is very little incentive to keep the costs down. By reimbursing costs and giving the Contractor a set fee, the Owner takes risk of potentially significant cost overruns on the project. As a way to protect themselves from the risk, many Cost-Plus Contracts include a Guaranteed Maximum Price (GMP). The Guarantee Maximum Price is the maximum the Owner will have to pay under the contract which shifts project risk back to the Contractor. Usually when there is a Guaranteed Maximum Price, there is also an incentive for the Contractor. For example, an Owner may share the savings when a project is completed below the GMP. Another alternative is for the Owner to give the Contractor an incentive bonus for completing the project on time and within budget.
Contract Surety Bonds and Cost-Plus Contracts
Cost Plus Contracts are ideal for Contractors and their surety bond companies because they significantly reduce the risk of default or payment issues on a project. In fact, if a contract is Cost Plus without a Gross Maximum Price, most surety bond companies do not even count the project against a Contractor’s backlog for surety bond capacity. These types of projects rarely require Performance Bonds or Payment Bonds. Conversely, if the project has a Gross Maximum Price, the surety bond company must count it toward a Contractor’s program. These projects do carry risk of default by the Contractor and the Owner often does require Performance Bonds and Payment Bonds on these types of projects to guarantee that the Contractor will not exceed the maximum price.
It is important to note that Owners and General Contractors often require performance and payment bonds from subcontractors on Cost Plus Contracts even when there are no Contract Bonds between the Owner and General Contractor. Because the Owner is absorbing the cost of subcontractors, they want to make sure subcontractor performs according to their contract. This is a way for Owners to reduce their risk of cost overruns on a Cost-Plus Contract.
Time and Material Contracts
Time and Material Contracts (T&M) are an agreement between a Contractor and Owner where the Owner agrees to pay the Contractor a set price for time spent on the project plus any materials the Contractor uses. Usually the Contractor gives the Owner a set price whether by the hour, day, etc. that incorporates the Contractor’s costs and profits. Time and Material Contracts are appropriate when bidding and pricing each project would not be cost effective. Often these contracts involve maintenance. An example may be an Asphalt Contractor filling potholes and repairing asphalt. Each individual repair may be insignificant so the Contractor charges Time and Material.
Time and Material Contracts and Contract Surety Bonds
Time and Material Contracts almost never require performance or payment bonds. These contracts present the least amount of risk to a Contractor and the most amount of risk to the Owner. As such, these contracts are welcomed by surety bond underwriters. Time and Material Contracts are also not counted against a contractor’a backlog and surety bond capacity.
Design Build Contracts
You can read more about Design Build Contract and Contract Surety Bonds by visiting this page.
Understanding the type of construction contract and the risks associated with each is vital to both Contractors and Surety Bond underwriters. Other project delivery methods such as Public Private Partnerships and Integrated Project Delivery continue to grow, and each presents their own challenges as well. Contact MG Surety Bonds and our surety bond experts anytime with questions about how your project may affect your company and your surety bond program.