Understanding Lump Sum Contracts in Construction

A lump sum contract, also known as a stipulated sum contract, is one of the most common types of contracts in the construction industry. They operate on a simple basis: An owner-developer lays out the project scope of work (SOW), and then a contractor offers a fixed price — inclusive of materials, labour and additional overhead costs — to complete the project.

This contract is best suited for projects with a clear scope, as it allows for the most accurate cost estimates. Below, you’ll find out how lump sum contracts work, including their pros and cons and how they function in a hypothetical example.

How lump sum contracts work

A lump sum contract is an agreement that sets a predetermined cost for construction work. Under this arrangement, the contractor performing the work agrees to complete the project for a fixed amount – no more or less. Additionally, the owner-developer ties the contract amount to a specific scope of work, meaning the contractor is under no obligation to exceed the original scope.

Lump sum projects must have a well-defined scope. Otherwise, owner-developers may face unexpected costs and contractors may dispute the project requirements. Here is a breakdown of the documents that define the scope of a lump sum project (other documents may apply, depending on the project):

• General conditions of the contract — including roles, payment information, site conditions, variations, dispute resolutions and more
• Construction specifications
• Construction drawings
• Project programs
• Bill of Quantities

By reviewing the scope of work, contractors can comfortably:

1. Estimate the project cost
2. Add in a markup (profit and contingency)
3. Submit the final cost as part of a negotiated or competitive tender

When both parties sign a lump sum contract, it means two things: the contractor has agreed to the scope of work and the owner-developer has agreed to the price.

Also, owner-developers can use lump sum contracts in subcontractor agreements, where the subcontractor agrees to complete a predetermined portion of work for a fixed price.

Despite the namesake, the term ‘lump sum’ in this context (being a construction contract) refers not to the payment method but the way in which a lump sum project establishes a fixed, upfront budget. Under this arrangement, the contract lays out a program of progress payments, which contractors apply for — by proving that a certain percentage of work has been completed — and receive.

In most lump sum projects, owner-developers hold back a portion of each payment as retention money, which they pay out when the project is complete. This incentivises contractors to complete the entire project.

Changes of scope are common in lump sum projects, a process that involves a contractor submitting a Variation to the owner-developer. Both the owner-developer and contractor need to agree to the change of scope and sign the document to confirm the change of scope, plus the associated change to the price and program.

Even a project with a well-defined scope may require Variations. To anticipate these changes, owner-developers often budget (a certain percentage) above the fixed cost of the lump sum contract.

Advantages of lump sum contracts

Both owner-developers and contractors aim to benefit from lump sum contracts. The main drawing card of these contracts is their simplicity, as they are easy to budget for and easy to manage.

When all the pieces fall into place, both owner-developers and contractors benefit from the simple price structure of a lump sum contract.

Simplicity

Lump sum contracts are one of the easiest to draw up and understand, as the contract documents clearly state the work in question and how much money the contractor can expect to make at the end of the project. Owner-developers can more easily perform invoice management and budget for a project, as the costs are clearly defined before construction begins.

Financing

Owner-developers may find it easier to secure financing for a project using lump sum contracts (over other types of contracts), as lenders have a better sense of the project costs, making the loan easier to approve. Also, when owner-developers use lump sum contracts, they may have a lower contingency percentage — as in, a lower portion of the budget set aside to cover known-unknown risks — than those using cost-plus contracts, which often require more flexible financing or larger cash reserves.

Profit

Compared to other types of contracts, contractors with excellent estimating and project management practices may earn higher profits with lump sum projects. Since the entire project budget is set in stone ahead of time, the contractor can employ the most efficient construction practices to stay under budget, resulting in a higher profit margin. Also, head contractors, during the buyout process, can negotiate on tenders with subcontractors to generate even greater profits.

Overhead

Lump sum contracts may require less documentation and accounting than other types of contracts. For example, cost-plus contracts often require a more robust documentation of costs, whereas lump sum contracts assign a fee to the entire project. Therefore, contractors using lump sum contracts may have lower overhead costs, increasing their odds of submitting competitive, lucrative and profitable tenders.

Disadvantages of lump sum contracts

While lump sum contracts are simple, they also present risks to both owner-developers and contractors.

Owner-developers who use lump sum contracts must monitor their projects closely; especially their contractors, to ensure that their contractor’s work satisfies the project scope. Owner-developers should also budget accordingly for potential — but, in most cases, inevitable — changes in scope. Contractors who use lump sum contracts rely on accurate construction documents and project estimates. Plus, since these contracts require a higher degree of construction risk management for complex projects, contractors must submit accurate tenders. By doing so, they ensure that the project scope doesn’t creep into their profit margin.

Risk of inferior work

It is a sad but true reality that some contractors, on purpose, go under budget just to boost their own profit margins. To prevent this from happening, owner-developers should hire an onsite representative. These are trusted individuals who can, from an objective standpoint, ensure the construction is of a high standard and aligns with the original scope. With proper oversight, owner-developers enjoy greater peace of mind and contractors maintain their original markup.

Variations

Variations can happen on any project, but they are most common in lump sum contracts, especially when contractors are at risk of erasing their profits. As a result, owner-developers using this contract type must keep reserves on hand to account for potential price increases due to Variations.

Estimating challenges

Contractors using lump sum contracts need accurate estimates. If their estimates are unrealistic, they may go over budget and cut into their profit margin.

Scope disputes

Understandably, owner-developers have an incentive to keep Variations low on lump sum projects, which means that contractors need to fully understand the project scope. Otherwise, contractors may have their Variations denied and then be responsible for unaccounted costs.

Example of a lump sum contract

Lump sum contracts are quite common in the construction industry, but they can be hard to understand on purely technical terms. Below is a summary of a hypothetical construction project using this type of contract.

Picture this: an owner-developer wishes to build a high-rise apartment using a stipulated sum agreement. Working with a design firm, they produce a finished set of drawings and specifications. Then, they use these (and other) documents to put out a request for proposal. After reviewing tenders from head contractors, they award the contract to Brideshead Builders for a fixed price of $4 million, including all work required to complete the project.

Before submitting their final tender, Brideshead Builders – in order to fully understand their potential direct and indirect costs – consulted subcontractors and a construction estimator. These consultations also help them calculate their profit margin and percentage markup for contingency.

An important note: In some cases, another step in the tender process, called Clarifications & Addendums, may also occur. During clarifications, contractors, before submitting their final price, will review the tender, making sure they fully understand all aspects of the project and the SOW.

Additionally, if the contractor cannot determine the value of a Scope item, they will then use a Provisional Sum line item. This, in theory, forms the Cost+ section of a lump sum contract. Provisional sums can be based on daywork rates. Or the contractor, after fully grasping the work required for the scope, will re-price the works, locking them in as lump sums.

Throughout the project, the owner-developer makes progress payments to Brideshead Builders, who use a portion of that money to pay what they owe their subcontractors.

Along the way, changes occur. The flooring contractor, after reviewing the upper floor, has to order a new material, one that is not in the original project scope. Additionally, due to a change in site conditions, a mechanical contractor has to request new equipment. As a result, both subcontractors submit an RFI to the head contractor, who then passes on the request to the owner-developer. Fortunately, the owner-developer approves these two requests, officially adjusting the project scope.

As the project nears the finish line, the head contractor remains focused, keeping the project within budget – while maintaining the highest quality – to satisfy the client and turn a healthy profit. When the building reaches the substantial completion stage (either at, or before, the agreed date), the subcontractors receive their retention payments.

Once the head contractor hands over the building to the owner-developer, they receive the final fixed price payment. They then make the final payments to their subcontractors. 

Under Australian Law, contractors must pay subcontractors for completed work, even if the contractors have not been paid yet. Since lien waivers are not common practice in the APAC region, a head contractor will instead submit a Payment Declaration, stating they have paid all subcontractors and wages on the project.

When all goes well, all parties — the owner-developer, head contractor and subcontractors — benefit from the lump sum pricing structure. Owner-developers find it easy to calculate their return on investment (ROI), while head contractors and subcontractors enjoy a healthy profit margin.

Lump sum contract template

Many organisations use contract templates for lump sum agreements. These contract templates can be found at the Australian Institute of Architects (AIA) and the Housing Industry Association (HIA) websites, respectively. The HIA website is particularly useful, as it enables contractors and owner-developers to create and manage their contracts in a secure, online portal.

When using a template to create a lump sum agreement, have a construction lawyer review the terms and modify the contract as necessary for the specific project. 

Construction contract types compared

Lump sum agreements are just one of many types of construction contracts.

Other frequently used contracts include guaranteed maximum price (GMP), dayworks and unit price. 

Below, we’ll offer a brief comparison between lump sum contracts and other contract types.

Guaranteed maximum price (GMP) vs lump sum contracts

GMP contracts set an upper limit for the costs incurred during a construction project. Above that limit, the contractor (often a head contractor or construction manager) absorbs the additional cost. Like lump sum contracts, this simplifies the budget for owner-developers.

However, the risk can be higher for contractors, who are bound by the final contract price and must estimate and budget carefully for the project.

Cost-plus contracts vs lump sum contracts

Cost-plus contracts pay for all project costs plus a predetermined profit margin. This type of contract benefits contractors, as they know that the project will be profitable before it even begins. On the other hand, cost-plus contracts can be risky for owner-developers, who may not know the total cost before the project begins. For that reason, cost-plus contracts may include a clause setting a maximum price, which helps glean some of the benefits that owner-developers associate with lump sum contracts.

Daywork contracts vs lump sum contracts

Daywork contracts require contractors to bill for all material costs as well as labour costs at a predetermined hourly rate. The rate that contractors set for materials and labour includes their profit margin, so contractors typically stay profitable regardless of the number of hours of work required and completed. Unlike lump sum contracts, which require a well-defined scope of work, daywork contracts are often used for projects where the scope is less certain.

Unit price contracts vs lump sum contracts

Unit price contracts define a set cost for a ‘unit’ of work, which is a repeatable pattern of materials and labour. For example, constructing a 1.6-kilometre stretch of highway involves the same equipment, materials and labour, so the contractor can determine the per-unit cost for highway work. When the number of units increases or decreases, the cost increases or decreases by a predictable amount. Unlike lump sum contracts, which are used for projects with a predetermined scope, unit price contracts are often used for repeatable work where the exact amount of work required is not known.

Contracts and construction finance

Contracts are one of the cornerstones of financial management in construction.

Ultimately, some of the most successful owner-developers and contractors are those who employ the right contract for the right situation. Contractors must support their contract formation with a strong process for estimating, tendering and managing the project.

In the case of lump sum contracts, owner-developers and contractors who ensure that the scope is well-defined and the project execution is excellent, will benefit from the simplicity (and potentially higher profit) associated with a fixed sum.

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