All construction contracts address critical aspects of a project, including its scope of work, price and payment terms, schedule and an explanation of each party’s rights and responsibilities. However, lump sum contracts have specific criteria that can be both a benefit and a hindrance to a construction project.
What Is a Lump Sum Contract?
Under a lump sum contract, also known as a stipulated sum contract, the project owner provides explicit specifications for the work, and the contractor provides a fixed price for the project. These contracts require the owner to complete the project’s plans, designs, specifications and schedule before the contractor can establish a price. The contractor then estimates the costs of materials, tools, labor and indirect costs such as overhead and profit margin and provides a quote.
If the project’s final costs are lower than the contactor’s estimate, then their profit increases. If the estimate is too low, the contractor’s bottom line suffers. However, the project owner’s finances are unaffected in either scenario.
So, what does lump sum mean in a contract? Despite the “lump-sum” moniker, this term refers to how the project is priced rather than the payment terms. With these contracts, payment usually occurs on an installment basis. This can be as project benchmarks are met or in regular increments (e.g., monthly).
To modify a lump-sum contract, project owners must submit a change order document that the contractor must approve along with any price changes. That makes lump-sum contracts somewhat inflexible, but they provide a reliable price for owners and reliable revenue for contractors, making them one of the most popular types of construction agreements.
Contractors and project owners often wonder, “what is the difference between fixed price and lump sum contracts?” Simply put, these terms are interchangeable and are two names for the same concept. However, there are some crucial distinctions between lump sum contracts and other construction agreements.
Lump Sum vs. Cost-plus Contracts
Cost-plus contracts are similar to lump sum contracts in that the owner agrees to pay the contractor’s costs, including labor, subcontractors, equipment and materials and an amount for the contractor’s profit and overhead. But instead of a lump sum to cover all the expenses, those costs are reimbursed individually.
These agreements do not require the project owner to have finalized plans for the project. That means that the scope and cost are subject to change. Unlike lump-sum agreements, owners take on more risk and will benefit or be disadvantaged if the final costs are lower or higher than estimated as they are directly reimbursing the contractor’s expenses.
There are three types of cost-plus contracts:
- A cost-plus-fixed-fee contract where the contractor is paid a base amount independent of the final project cost.
- A cost-plus fixed fee with a guaranteed maximum price contract where the contractor’s compensation is based on a fixed amount that does not exceed a specific threshold.
- A cost-plus fixed percentage contract where the contractor’s compensation is based on a percentage of the cost.
These contracts are most common when designs, plans or other specifications are still in flux, but the owner still wants to begin construction, such as when the project is on a tight schedule.
The main advantage of cost-plus contracts for both owners and contractors is that the work likely gets done to specifications because the contractor won’t incur any extra costs for increased materials or labor costs. However, contractors and project owners must track costs and supervise the project carefully to ensure fair payment, requiring more burdensome paperwork and oversight.
Lump Sum vs. Time and Materials Contracts
Time and materials (T&M) contracts stipulate that the owner provides reimbursement for materials and a daily or weekly payment for labor costs. Like cost-plus contracts, time and materials contracts work well with project specifications and scopes that are still ambiguous as the project starts.
T&M contracts provide contractors with a daily or weekly rate, providing a steady income. Project owners benefit from the adaptability of these agreements, ensuring that the work occurs to specification.
Time and materials contracts require additional paperwork compared to lump sum contracts because labor costs must be recorded accurately.
Lump Sum vs. Unit Price Contracts
For unit price contracts, the price is based on the estimated per-unit cost of the materials and is divided into stages, usually by construction trade (e.g., carpentry, electric, plumbing and more). For this reason, unit price contracts are standard in subcontracting agreements. Many painting contracts, for example, follow a unit-price structure as painting is generally charged on a square-foot basis.
As with cost-plus and T&M contracts, unit price contracts benefit project owners when they have a general idea of the project that needs to be done, but the concrete planning isn’t completed. For example, you may establish a per-square-foot price for flooring and installation, even though you don’t know exactly how many square feet of flooring you’ll need covered. Because you know approximately how much materials and labor would cost, you can establish a unit price for this and other aspects of a construction project. Contractors can get a handle on good approximations of costs and revenue from each stage. Both owners and contractors can adapt the project as necessary without having to submit change orders and renegotiate prices, as they would have to do with a lump sum contract.
A notable shortcoming is that there is a significant risk of cost overrun since these contracts usually lack a unit threshold.
Lump Sum vs. Guaranteed Maximum Price Contracts
A guaranteed maximum price contract (GMP), also known as a not-to-exceed price contract, requires owners to compensate contractors for their direct costs as well as a fixed fee for overhead and profit — but only to a certain threshold. The contractor is responsible for additional costs once reaching this amount. The maximum price can be increased via a change order if the project’s scope changes, but not for errors or cost overruns.
Remember, with lump sum contracts, whether or not the project actually cost the estimated amount, the contractor gets the same amount. That is not the case with maximum price contracts and the owner, not the contractor, will keep cost savings if things come in under budget. In some cases, the owner can share a portion of any savings with the contractor to encourage timely work and keep costs low.
These contracts are suitable for owners who have a tight budget as there is an absolute upper limit. For contractors, however, GMP contracts increase their financial risk if costs exceed the limit.
When Would You Use a Lump Sum Contract?
Lump sum contracts are standard in construction projects, but they aren’t suitable for every situation. These contracts work best for projects with finalized plans, clearly defined scopes and schedules and proper documentation of all assessments and other pre-construction activities. These aspects are crucial to allow the contractor to estimate project costs and provide the lump-sum amount accurately.
These agreements are best suited for simple projects with subcontractors, specific parameters and a low risk of unforeseen problems.
When all of these elements align, lump sum contracts provide an uncomplicated agreement that both project owners and contractors can easily understand and agree on. But what are the advantages and disadvantages of a lump sum contract? Advantages for owners include simplified accounting and little financial risk, and disadvantages include rigidity in project scope and a need to have every detail planned before beginning the project. Advantages for contractors include clear directions, less paperwork and a potential for profit if the project comes in well under budget, and disadvantages include risk if the project is more costly than expected.
Advantages of Lump Sum Contracts
The simplicity of lump sum contracts provides benefits for both owners and contractors.
Advantages for project owners
The predictability of lump sum contracts is the primary benefit to project owners. The owner can expect the project to be completed within budget and often more quickly so that the contractor can maximize resources and save on labor costs. Lump sum contracts also render little financial risk for owners as the contractor is responsible for any cost overruns. These factors make it easier for project owners to obtain financing since lenders prefer to fund defined projects with clearly delineated costs.
Owner supervision of lump-sum contracts is minimal as the owner does not need to track costs. Also, the payment structure of lump sum contracts usually comprises regular payments at specific iterations or as a percentage of the work that has been completed, simplifying accounts payable processes.
Advantages for contractors
Despite the increased financial risk of lump sum contracts compared to some other types of agreements, contractors still receive many benefits.
Under a lump sum agreement, project owners must provide contractors with finalized plans and thorough documentation, resulting in specific, linear project tasks. Lump sum contracts also require less paperwork, management and accounting, decreasing administrative costs.
Another advantage of lump sum contracts is that they do not require contractors to disclose how they calculated their materials or labor costs, allowing them to provide estimates with sufficient cushion to avoid going over budget. If the project is under budget, the contractor keeps the profit.
Disadvantages of Lump Sum Contracts
Lump sum contracts can have downsides for owners and contractors, as well.
Disadvantages for project owners
Owners must submit and adhere to completed designs and finalized plans, making the project inflexible. If a change is needed, lump sum contracts stipulate the use of a formal change order process and a considerable amount of paperwork.
There is also the risk of being charged a higher amount to cover the contractor costs for unforeseen situations. Similarly, contractors could use inferior materials or otherwise cut costs to increase their profit from the fixed price. That’s why it’s prudent for owners to specify materials in the pre-construction documentation they provide to the contractor.
Disadvantages for contractors
Contractors incur the cost of going over budget, which can eat into profits. Contractors also share the disadvantage of time-consuming change order paperwork if modifications need to occur.
Variations in Lump Sum Contracts
Variations are prevalent triggers of disputes in construction projects. With lump sum contracts, any change in the plan, scope or costs is considered a variation. The most common causes of variations include:
- Design errors, omissions and discrepancies
- Incorrect interpretation of plans or designs
- Specification changes
- Increases or decreases in necessary material quantities
There are two types of variations. Beneficial variations reduce or eliminate costs, shorten the schedule or otherwise improve the project, which can be a boon to owners and contractors. Detrimental variations negatively affect costs, time and other aspects of the project, such as discovering an unexpected water main which results in an overhaul of the original construction plans.
In either case, some variations require a formal change order request from either the owner or the contractor. Change orders must include four key points:
- A comprehensive description of the requested modification
- A credible justification of the change
- An estimation of the costs of the proposed change
- An explanation of the impact that the proposed change could have on the project completion date
Modifications cannot occur unless all parties agree to the new terms. That often requires negotiations that can go on for some time, halting work.
Lump sum contracts are designed to reduce variations significantly, but they can still occur if there are overlooked details or unforeseen circumstances. Ensuring that all materials are available, the design and plan are accurate and that everyone fully understands the project can further protect project owners and contractors from time- and money-consuming variations.
Common Issues With Lump Sum Contracts
While lump sum contracts are straightforward and reduce many common construction contract headaches, they are not without issues that can have varying impacts on project owners and contractors.
Delays are often consequences of unforeseen circumstances out of either party’s control, such as weather or supply chain disruptions. Other times, a lack of clarity, failure to provide timely instructions, inadequate labor or a lack of equipment or materials is to blame.
Lump sum contracts should include provisions that stipulate the circumstances under which each party would be responsible for delays and the associated costs. That can reduce the risk of contract breaches as well as the need for time-consuming and costly litigation.
The price of labor and materials can be fluid and subject to change throughout the project. Lump sum contracts generally do not account for these fluctuations, so contractors have to absorb the cost if prices rise. However, they can also realize savings if rates go down. These risks are arguably more pronounced in extended projects.
Contractors must factor in possible upward fluctuations and price the project accordingly when providing the estimate.
Although lump sum contracts are pretty iron-clad as far as scope and cost, provisional or stipulated sums refer to the price of optional project work. The provisional sum is included as a separate estimate within the contract and only changes if the owner decides it’s a good idea to move forward with the elective work.
The work associated with stipulated sums can cause issues with the project schedule, primarily if implemented later in the project. It can also lead to modifications that require formal change orders. That’s why it’s essential that the terms of a lump sum detail how to handle provisional sums and the limits of any related changes.
Lump Sum Contract Construction Example
It’s essential to develop a lump sum contract correctly and fulfill it to the letter. But what is a lump sum contract in construction? It’s one kind of construction contract where a single price is used for an entire project. The estimated cost is developed after the contractor understands all the details of the construction project, including specifications, materials and timelines. Proper creation and execution of a lump sum contract for a construction project look something like this:
A project owner needs to build a storage shed to increase inventory space, so he approaches a contractor for the job. The owner has already completed the building design and construction plan, performed the necessary surveys and received the required permits. In the construction plan, the project owner also notes that he would like to use a particular cement brand.
The contractor evaluates the documentation and calculates how much the labor and materials will cost. She takes the pricier cement that the owner requested into account and includes a buffer amount to allow for unanticipated expenses. She then adds another amount to cover overhead and profit to the final project estimate.
The project owner agrees to the price, and the lump sum contract:
- Adequately lays out the scope of the project
- Contains robust project modification controls
- States a price that includes all costs related to the project
- Details who is responsible for various additional costs
- Delineates provisional sums and the associated work
- Includes the estimated completion date
Both parties agree to the contract’s terms. The work, which should take six months, begins. The owner pays one-sixth of the fee every month.
Halfway through the project, the project owner decides to install tile flooring over the concrete. That is outside of the original agreement’s scope, so the owner submits a formal change order that the contractor reviews and then provides a new estimate for the project. The project owner agrees, and work continues. Installing the tile pushes the estimated completion date out by two weeks and increases labor costs for the contractor, but the additional amount that was agreed to via change order protects the contractor’s profits.
When the project is complete, the contractor managed to come in under budget, providing her with additional profits.
Accounting Software for Lump Sum Construction Contracts
Managing risks, variations and other lump sum contract issues is seamless with the right accounting software. Accounting software can improve all aspects of accrual basis job cost accounting, including billing, bookkeeping and financial reporting. It can automate cost calculations, perform payroll tasks and keep track of payables and receivables. Single-entry functionality can also eliminate some manual data entry.
Accounting software for construction projects often includes job cost modules to track project-related purchases, labor costs and overhead. This kind of accounting software can also track details down to project tasks and be applied to contracts, allowing contractors to track the original lump sum contract amounts and any change order amounts. It’s also possible to put controls into place that establish a threshold for costs to ensure that the project stays within budget.
While they are one of the least complicated types of construction contracts and have a myriad of benefits for both owners and contractors, lump sum contracts still require careful consideration and execution. Utilizing capable technology is imperative so lump sum contracts perform as intended. Financial management software can help contractors expedite contract processes across the board, from developing an estimate to implementing modifications to processing final payments.