Lump Sum Contract: What Is It?
Lump sum contracts are an essential form of contract, particularly in the context of construction and other project-based work. Rather than outlining various items of work, lump sum contracts specify a total price for the work to be performed. Within the construction industry, some may refer to these types of contracts as fixed-price or fixed-fee contracts. Regardless of the name, the basic idea is the same. The contractor is agreeing to complete the entire scope of work for a specified price.
Lump sum contracts generally set forth in detail a description of the work to be completed. They rarely, if ever, identify the unit prices to be charged for each item of work to be completed, if it is even appropriate to label the items "unit prices." Instead , the lump sum contract specifies a lump sum to be paid once the entire scope of work is complete.
The purpose of the lump sum is to provide both the owner and contractor with an incentive to minimize waste and maximize efficiency with costs during the construction process. The lump sum contract is essentially a private agreement between the owner and the contractor. Almost always, the cost of the entire project will be substantially less than the contract amount, assuming no change orders or significant disputes arise. The lump sum contract provides owner with a certain amount of protection that the project will be completed on time and within budget. But, it also provides the contractor with the opportunity to maximize profit by implementing techniques to increase efficiency.
Because lump sum contracts reward efficiency, it is the most commonly used method of contracting in the construction industry for heavy civil projects. In addition to the construction industry, lump sum contracts have gained popularity in other industries, such as software development.
Lump Sum Contracts: Main Characteristics
Lump sum contracts are characterized by the following key features:
Fixed price structure: The main feature of a lump sum contract is, as the name suggests, a fixed price for the entire project. Along with a predetermined timeline, this forms the crux of the mutual agreement between the parties.
Scope of work: The contract will generally spell out the scope of the project that is to be addressed. An important thing for both contract and regulatory purposes is the distinctions between quantities and estimates, particularly in connection with applications for permits and zoning approvals.
Responsibility of parties: The contract will lay out the common responsibilities of the parties, including provisions about scheduling and payment terms.
Change orders: As described in this guide, lump sum contracts (like other forms of contracts) allow for the possibility that the scope of work will change. Employers and workers usually address changes through the issuance of change orders, which will include both the nature of the approved change and the budgeted adjustment to the costs, schedules, and labor requirements.
Benefits of Using a Lump Sum Contract
When it comes to legislation, litigation and construction, the early bird doesn’t always get the worm. A traditional developer might recall how lessons from a brutal economic downturn left behind technological changes and some innovators with more courage than experience. Still, many in the industry gravitate to time-tested, conservative methods of doing business. For example, a lump sum contract is a tried-and-true policy that works for many. It has advantages, while sometimes being underestimated. Let’s take a look at the plus side of lump sum contracts.
The advantages of a lump sum contract are as follows: Lump sum contracts offer cost certainty. The general contractor, under such a contract, guarantees the project will not exceed budget. It stipulates the maximum price for the contractor’s work. Even if the project ultimately costs less, the contractor is paid as though it were higher. While advantages transpire on both sides — the owner receives peace of mind, while the contractor can plan out specific profit margin figures — the owner still has the upper hand. If the contractor goes over budget, it eats the difference. For example, if the budget is $40,000, but the project actually costs $45,000, the owner simply pays $40,000. In this case, lifestyle choices of the contractor are irrelevant to the owner.
However, while this system rewards the contractor for staying on budget, it also exposes him or her to risk. Contractors may overbuild to hedge against cost variation, or inflate the budget to pad their profits. After all, when the project is done, they may pay out the full lump sum amount for less than it ended up costing. In the end, lump sum projects end up being profitable for contractors — unless an unusual occurrence, like an accident at work site, derails timely completion or excessive budget variance.
Many owners value lump sum contracts for their simplicity. The lump sum agreement itself is just one paragraph to three pages long. It includes only the price, schedule and a few basic conditions. Despite this elementary structure, both parties know what to expect and the parameters for budget and time. Once accepted, the contract is binding.
The owner benefits from simple payment obligations. Usually, tenants pay rent on a monthly or biannual basis. If the problem arises that rent, gas, light or other utilities cannot be paid, the owner could face some real legal problems. With a lump sum contract, the contractor must pay all its bills associated with construction. You may have seen a runaway construction project and a contractor feeling entitled to funds from the landlord.
By guaranteeing its work to stay on budget, the contractor assumes more responsibility for estimating costs, drafting a budget, purchasing supplies, scheduling sub-contractor work, hiring laborers and documenting expenses. It is true the owner assumes more risk when a lump sum contract is agreed upon, but it offsets those risks with the simplicity of lump sum payments.
Lump Sum Contract Disadvantages
A major risk of a lump sum contract is related to scope changes. Unless the contractor has negotiated specific change order language or another way of addressing scope changes, the contractor could be out of luck if change orders are necessary. Often, the party negotiating the contract does not focus on this issue and fails to protect itself. It is usually preferable to have a specific process outlined in the contract for revising the scope of work or paying for extra work.
Lump sum contracts may be used on collaborative projects where there is strong confidence by the project participants about the scope of the project and the level of detail of the documents. However, if it any way possible, a lump sum contract should not be used on a project where there will likely be disputes about the scope or problems with the design documents. Adjustments in the contract price may be more appropriate in a situation where it is uncertain if there will be scope changes or errors in design, but more likely than not.
The nature of a lump sum contract makes it unlikely that the parties are planning to alter the contract price, time of completion, or the scope of work. With a change order, the parties are expressly providing for adjustment of the contract terms. A lump sum suggests that the parties have agreed upon all of the contract terms. Once the contract is signed, there is likely to be a dispute if anything changes.
An additional risk is that the contractor will incur costs in excess of the lump sum amount. This risk is especially heightened where the project involves a complex design or construction process. A contractor who is confident in its ability to predict the costs associated with the project before it begins is generally not inclined to sign a lump sum contract.
Construction projects often have many unknowns that can make a lump sum an unattractive proposition for the contractor.
Comparison of Lump Sums with Other Types of Contracts
Cost-plus contracts and time-and-materials contracts are two other common types of contracts that are often used in the construction industry. A cost-plus contract is one where the owner pays the contractor for all costs related to the work, plus a fixed fee for the contractor’s profit. This type of contract can be advantageous for both parties when the scope of work is not precisely known, as it allows the owner to pay only for the actual costs incurred by the contractor.
Time-and-materials contracts, on the other hand, typically involve a fixed hourly rate for both labor and materials, with the owner providing or purchasing the materials separately . This type of contract is often used when the scope of work is uncertain or the project involves an ongoing relationship between the parties, as it allows for flexibility in pricing.
While lump sum contracts can provide certainty of price and risk allocation for both parties, they also carry the risk of being too inflexible for some projects. In cases where the scope of work is uncertain, or the project involves an ongoing relationship between the parties, a cost-plus or time-and-materials contract may be more appropriate. However, in cases where the project is well-defined and the parties desire a set price and risk allocation, a lump sum contract is often the preferred choice.
When Is a Lump Sum Contract Needed?
In their purest form, lump sum contracts are most appropriate when the project in question is clearly defined. Therefore, it is those who plan or oversee a project who should be best able to know when to implement a lump sum contract.
Lump sum contracts are considered ideal during the design phase of a project, when the cost of the job is fixed and agreed upon well in advance of its start date. As the client is working with the firm throughout the design process, this allows a relatively accurate picture of the scope of the work to be completed. Because the client commissions the work from the firm, it is assumed that the two parties will work closely together on the details, so that the design is suitably rendered.
Once the project has been determined and the costs organized, the construction is fixed in time and budget. It is at this phase that a lump sum contract would be appropriate, as everyone will benefit by staying within the budget set. However, problems can arise if additional work must be done later that is not covered by the lump sum contract, as this could reverse the benefits for one or both of the parties. In particular, it may be a good idea to set some ground rules for how additional costs will be determined and how they will be shared.
Lump Sum Contract Negotiation
In any negotiation for a lump sum contract, the devil is in the details. Here are a few tips to make sure that the project stays intact and the parties can relish their negotiating skills long after the deal is done:
Review the Contract Documents Carefully. While scope of work is a generally acknowledged item of prime importance, it is recommended that the entire contract be reviewed for completeness and clarity in the definition and allocation of all risks – party A’s responsibility for this, party B’s responsibility for that and so forth. Review all payment items, and accept only those which are clear and unambiguous with respect to scope of work, payment, timing and other important aspects. Redline all ambiguous terms for clarifications and if clarification cannot be obtained, you should advise your client otherwise.
Get a Firm Understanding of Payment Terms and Work Sequence. Research the benchmark "typical" payment terms, and discuss any potential objections for a more or less favorable situation. It is better to enter the negotiations knowledgeable, than to bind yourself to unreasonable terms. A good rule of thumb in negotiating progress payments is an up-front payment, one-third upon mobilization, one-third for each increment of completion thereafter, and the balance when work is complete and accepted. In the case of a lump sum contract, such as the design/build contract, payment terms may affect the cost of the final product when the final amount is grossed up for the seller’s financing charges, insurance and similar soft costs.
Do Not Hesitate to Make Change Orders Obtainable. This is not a "take it or leave it" provision. If the scope of work is not clearly defined, ask for change orders immediately upon the occurrence of any change. If there is any dispute as to the scope of work, ask that the disagreement be referred to third party resolution immediately. While you may be unable to prevent disputes, you can make provisions for their timely resolution.
Limit the Time for Completion or Deficiencies. Seek to have time limits for completion that are reasonable in scope, and limit the time from the beginning of one work package to the beginning of the next, or from the start of work to completion, to avoid demobilization, remobilization and similar extraneous costs.
Negotiate Force Majeure to Your Advantage. It is an acceptable and reasonable practice to exclude certain events of force majeure from liquidated damages or similar penalties. Be sure to include all possible events of force majeure, as defined by law, regulations or other well-accepted authority.
Include an Ample Allowance for Rock Excavation. If your project involves mass excavation, an adequate allowance for estimated rock removal should be made. If during excavation an excessive amount of rock is encountered, you should be paid to remove it. However, bears in mind that an up-front allowance for rock excavation must be set fairly high, or you will likely lose out to a lower bidder.
If it looks like a lump sum project, but it is really a series of unit price contracts, then make sure you are adequately compensated for putting all the pieces together. Some work is only appropriate as a lump sum, but it is not always the lowest price. For example, lump sum contracts for work such as early site grading, erosion control, screening, dewatering, site clearing, demolition and excavation bottom preparation are often more costly than pricing the work in unit price form, and should not be used unless the contractor is being compensated extra for the administration work involved.
Finally, always reserve the right to audit the project and make sure that you get the transparency you need to honestly assess the project you are bidding on, so that you can evaluate any changes, modifications and/or site conditions fairly, yet with the benefit of the original contract terms intact.
Lump Sum Contract and Legal Issues
When entering into a lump sum contract, it is critical to consult relevant laws and regulations that may affect the agreement. Some of these may include: Licensing and Registration: It is essential to ensure that the contractor is registered and licensed as required by state or local law. Contracts entered into with unlicensed individuals or entities may be invalid or unenforceable. Adherence to Building Codes: The contract should state that the contractor agrees to comply with all applicable building regulations. Failure to do so could result in fines, penalties, or the need to redo the work, all of which could increase the cost. Negligence and Liability Provisions: Liability clauses are an important consideration in lump sum contracts. They should outline how liability is handled in the case of defective work or project delays. If a liability waiver is included, the homeowner should understand that the warranty may be voided. Unconscionable Contracts: In some cases, lump sum contracts may be unconscionable. These are contracts where the terms are unjust or overwhelmingly one-sided in favor of the other party. If a court finds a contract to be unconscionable, it may refuse to enforce the unfair terms . Consumer Protection Laws: Many states have consumer protection laws in place designed to safeguard homeowners from unfair or deceptive agreements. Lump sum contracts may fall under these statutes, particularly if the wording is misleading or if it omits crucial information. Canceling a Contract: Lump sum contracts are legally binding. If a party wants to cancel or modify terms, it is only possible if it is done in accordance with the law. Terms for modifying the contract should be clearly stated, including how the parties can renegotiate or correct errors in the lump sum amount. Non-Performance and Breach of Contract Provisions: These provisions outline what constitutes non-performance or breach of contract. Should the client feel the lump sum work was not done properly, he or she can seek arbitration or damages. Clarification of Legal Jurisdiction and Governing Laws: It is also vital to specify the jurisdiction and governing laws. This is relevant in the event of a dispute. Applicable Laws and Regulations: There may be circumstances in which a federal statute, regulation, or other ruling may prevail above the agreed-upon terms.