Unlike other industries where companies get to determine how and when they charge for services, subcontractors often have little control over this. The owner and GC typically decide these factors well before subs get involved. And the bigger the client or GC, the less likely subs can negotiate more favorable deals. Rarely do you, as the sub, have any say over how the contract is structured or when you’ll get paid for your services.
That said, it’s important to understand that there are four main types of construction contracts between GCs and subs:
- Fixed price/lump sum
- Time and materials
- Unit price contract
The majority of the projects your company bids for will likely have fixed price (a.k.a. lump sum) contracts. (In fact, CoConstruct found that 80% of the 38,000 projects entered in its software from 2018-2020 were fixed price.) It’s the type of construction contract that GCs prefer. But it’s not the only option, and it’s important to know the differences and what you’re getting into when you sign a contract.
Continue reading this article to learn:
- How each type of construction contract works
- The pros and cons of each contract type
- When you can bill for each type of contract
- Tips to improve your construction billing processes
Common Types of Construction Contracts: Pros and Cons
If you’re only accustomed to fixed-rate projects, you might not be familiar with how time and materials, cost-plus, or unit price contracts work. It’s important to understand the ins and outs of each, plus the benefits and drawbacks they might have for your company.
Fixed-Price ( A.K.A. Lump Sum) Contracts
Fixed-priced contracts are the most common type of construction contract between subs and GCs and likely what you’re most accustomed to dealing with.
In this type of contract, all parties agree to a set price for the entire project before work begins. This means contractors must be able to accurately estimate labor, materials, and all other project costs in order to produce a well-defined scope of work. However, fixed-price contracts can still be altered or amended by change orders.
Pros of Fixed Price Contracts
- Project owners tend to favor fixed-price contracts because this model reveals their full exposure for a project and allows them to compare bids easily. They don’t have to get caught up in details like hours, labor rates, material costs, or markups. They only need to be concerned with the proposed total project price.
- Contractors who have solid estimating and bidding processes can cushion their fixed price bids to allow for a healthy profit margin. They can also increase their profits if they come in under projected labor hours or find materials at lower prices than originally scoped.
Cons of Fixed Price Contracts
- You need more time and resources to prepare bids for fixed-price contracts. You need to accurately plan for all stages of a project and account for all time and materials just to put together a proposal.
- Inaccurate estimates, rising costs, and other unforeseen changes can negatively impact profitability.
- It takes due diligence to measure project profitability accurately. If you’re not careful about tracking and managing costs, your entire profit margin can disappear.
- Fixed rate contracts can incentivize contractors to cut corners in order to increase their profit margin.
Time and Materials (T&M) Contracts
When the scope of a project is unclear, time and materials contracts can be a beneficial option for contractors. This type of contract enables them to charge for all material and labor expenses at an hourly rate. Here’s what you need to know:
- Material costs: This usually includes the price the contractor pays for materials, freight charges, storage fees, plus a markup. Most markup fees range from 10 to 30% of the total material fees.
- Labor costs: This includes base pay for all laborers, any overhead and administrative costs, and a profit margin. You don’t need to break labor costs out separately, just factor overhead, administration, and profit into your labor rates.
Although the final cost is undetermined, you do need to provide a rough cost estimate by listing your hourly rate, an approximate number of hours, and a general list of materials.
Pros of Time and Materials Contracts
- It’s faster to prepare bids for time and materials contracts. You don’t have to worry about creating a perfect estimate or identifying all the variables upfront.
- Time and materials contracts are less risky for contractors. They’re a good solution for contractors who struggle to generate profit.
- They allow for fluctuating materials costs. Think about the skyrocketing lumber prices in 2022 or the countless other supply chain issues you’ve encountered in the last three years.
Cons of Time and Materials Contracts
- You have to track all time and materials in order to accurately bill for the project. This increases the administrative burden on project managers and the back office.
- There’s no incentive for you to finish early or reduce project costs. This can pose a problem both for you and the project owner by drawing timelines out extensively.
- The total cost is unknown at the start of the project and costs can significantly exceed the original estimate. This is a substantially higher risk for project owners. T&M contracts may include a “not to exceed” clause to help keep project costs in check. These clauses incentivize contractors to complete work on time and on budget to avoid cutting into their profit margin.
In cost-plus contracts, contractors bill for all project costs plus a set profit margin. They’re designed to cover both direct costs (like labor, materials, and equipment) and indirect costs (like insurance, office space, and administrative expenses).
Like T&M contracts, cost-plus may also include a “not to exceed” clause to keep costs under control. Some cost-plus contracts include bonuses or incentives to encourage contractors to complete work on time and under budget.
Pros of Cost-Plus Contracts
- Cost-plus contracts carry substantially less risk for subs. You know your costs are covered even if prices rise. And you’re guaranteed to make a profit.
- You don’t need to spend as much time agonizing over accurate estimates and project plans just to put a bid together.
Cons of Cost-Plus Contracts
- On the flip side, you can’t increase profitability by reducing costs or working more efficiently.
- Cost-plus projects can make for sloppy project planning because you don’t have to figure everything out in advance.
- You must accurately track expenses and submit detailed invoices. If you miss any documentation, you can wind up facing payment disputes.
- Many project owners are hesitant to use cost-plus contracts because they don’t know the full project cost before selecting contractors.
Unit Price (A.K.A. Measure and Pay) Contracts
Unit price contracts divide work into fixed-cost units, where contractors bill for each unit separately. Similar to cost-plus contracts, the unit price includes labor, materials, equipment, overhead, and a markup for profit.
These contracts are commonly used for projects built on repeatable elements, such as highway development projects that are priced per mile or multi-unit housing buildings priced per dwelling.
Pros of Unit Price Contracts
- As far as construction projects go, unit price contracts have the most straightforward billing process. You don’t have to break down hours or materials. You just bill per unit. You don’t usually even need to submit a schedule of values.
- These contracts are great for projects that are highly dependent on materials or situations where the total number of units is unknown.
Cons of Unit Price Contracts
- Poor pricing can put contractors out of business. If you fail to estimate the cost of materials and labor accurately, your profitability can turn upside down.
- Although property owners know the cost-per-unit, if they don’t know the total number of units required, they can wind up with a much bigger bill than anticipated.
Main Construction Billing Methods
Each type of construction contract has its own billing practices—specifically when you can bill for your work. There are three main construction billing methods: advanced billing, progress billing, and arrears billing.
This billing method requires upfront payment. While this method is ideal because you don’t have to front the cost of the project, it’s pretty rare. We sometimes see it when the project owner and contractor have a long-term relationship.
Advanced billing is mainly for fixed-price contracts, but it can work for a pre-defined number of units of a unit price contract. Pre-payment can be for the entire project fee or a portion of it.
Also known as AIA billing, this billing method is by far the most common billing method in construction and can be tied to any contract type. It’s almost always used on larger projects with big budgets and long timelines.
Progress billing lets you bill the GC or owner at regular intervals (like monthly or quarterly) or upon completing key milestones. Terms should be outlined in the contract, including when and how to submit your payment applications.
This method doesn’t allow you to bill until the project is finished. All types of contracts can use arrears billing. It’s the hardest to deal with because you have to cover all the project costs and don’t get paid until the work is complete.
In a way, any contract that allows retainage (and most of them do, regardless of the type of contract) is a form of arrears billing.
5 Tips to Improve Your Construction Billing Processes
Regardless of how or when you can bill for each project, the whole construction billing process is a headache. There’s way too much paperwork involved, and hardly anyone gets paid on time. To that end, here are a few best practices that can optimize your billing processes so you can get paid faster.
1. Establish clear payment terms.
The contract should define payment terms. Don’t be afraid to negotiate if the terms don’t work for your business. We know it’s tempting to glaze over contract details and sign the dotted. But it’s critical to take the time to review each contract before signing. Make sure that payment terms are clear and billing schedules are outlined. Watch out for pay-when-paid and pay-if-paid clauses.
2. Submit payment applications on time.
It takes long enough to get paid for construction projects. But if you don’t submit your pay apps on time, you run the risk of missing the entire payment cycle. So mark the due dates for every pay app and make sure all your supporting documentation is in order.
3. Follow up on invoices and pay apps.
Regular follow-ups are key to getting paid on time. We recommend following up after you submit your pay app to make sure it was received, processed, and approved. It’s customary to follow up again as early as the first day after the payment due date. Ask when to expect payment.
4. Reward early payments (and penalize late ones).
Offering a discount on early payments can be an effective way to incentivize GCs to pay you faster. On the flip side, applying a late payment fee can have the exact same effect. Consider adding both to your invoicing terms.
5. Use construction billing software.
You probably haven’t made it this far without some type of construction accounting software in place. However, there are other types of construction billing software that are built to streamline billing processes and help you get paid on time.
Siteline is a construction billing software for trade contractors that lets you generate, submit, and manage pay apps—precisely to each GC’s specs—so you can eliminate payment delays.
If you need a streamlined billing workflow that'll get you paid three weeks faster, book a demo of Siteline here.