Construction Contracts – Assessing Their Pros & Cons

The construction and contracting industry in Saudi Arabia is booming, and presents a significant growth opportunity, particularly with notable large-scale projects such as the Riyadh Metro, The Qiddiya Project, Neom and The Red Sea Project to name a few.

With the scale of opportunity present, the need for legal protection becomes greater, therefore we explore the construction contracting landscape, along with the pros and cons.

There is currently no specific construction law in Saudi Arabia, which enables related parties in the private sector to agree on the method to use for pricing, along with terms.  The key element to ensure is that agreements should be Sharia law compliant in order to ensure the terms are enforceable.

Construction contracts outline the contractor’s and project owner’s roles and obligations. The agreements come in various forms, and based on the type, one party may gain more than the other, that is, each contract has its benefits and drawbacks.

Lump-Sum Contracts

A lump-sum contract is the same as a lump-sum agreement or fixed price contract. It is one of the most basic and widespread in Saudi Arabia. The contractor undertakes to perform the job for a set fee, and the project owner agrees to pay the entire cost to the contractor.

The cost of the realization, acquisition of materials, and the marking by miscellaneous expenses and benefits are all in the price.

Pros

• Since the contracts are set in stone, completing them under budget means better profits.
• With anticipated costs, the owner bears minimal risk
• Lump-sum contracts are simple. The contractors don’t have to submit multiple bids and calculate the total price instead.

Cons

• The fixed price model is a risk to the contractor when the projects are vast. There is no room for errors, and any missteps with suppliers and subcontractors may lead to losses.
• Miscalculations can happen when the lump sum contract fails to account for all the variables. Unforeseen changes can reduce margins.

Time and Materials

In a time and materials agreement, the owner agrees to reimburse the contractor per hour in addition to the materials. The contract is most useful where the project’s scope isn’t well defined.

Pros 

• The contractor benefits because they do not have to estimate the cost of project completion as with a lump sum contract, and the owner benefits as they only pay for the actual time worked.
• The contract allows simple negotiations to cover the unforeseen expenses along the way.
• The hourly rate is straightforward

Cons 

• On the other hand, the contractor can be slow because they are paid for their time.
• It is no small task to log in the material costs every time and using the wrong amounts may reduce the profit margin for the contractor.

Cost-Plus Contracts

Also known as a cost-reimbursement contract, the cost-plus method involves paying the contractor for all costs incurred during the contract’s duration. The arrangement sets aside a particular amount as profit, usually a percentage of the project’s overall cost.

A cost-based pricing method is often a moving target and can go out of control. To prevent runaway costs, cost-plus pricing often combines with a guaranteed maximum price (GMP) to set the upper limit for fees and expenses. Anything above it goes to the contractor.

In a nutshell, the cost-plus contract covers the direct costs such as labor and materials, indirect costs, including traveling and communication, and the profit.

Pros

• Cost-plus contracts are flexible. Owners can make design alterations along the way, and the contractors know in advance what they stand to make after the alterations.
• Unlike lump-sum contracts, miscalculations are not detrimental, given the flexible nature of the arrangement.

Cons

• Cost-plus contracts require the justification of costs, and this sometimes is difficult. Owners may be unwilling to reimburse some indirect costs such as administrative expenses.

Unit Price

A unit price contract requires the contractor to establish price per unit of work divided into portions. The method is standard in public work. Also known as measurement contracts, the arrangement allows the contractor to forward the cost of every unit of work instead of an estimate for the whole project. Unit price contracts are practical when the task is tedious, and the material costs are not projectable.

Pros

• A simplified invoice is the contract’s strength, allowing for more transparency and fewer disputes.
• Ideal for well-defined and repetitive projects
• The profit margin stays the same even when there are changes to the scope of the work.

Cons

• The owner may insist on comparing the prices, which can cause delays.
• It may not be handy with private projects unless as part of other methods such as lump sum for particular work components.
• Estimating the final value of the contract is not a walk in the park. The amounts of units needed for project completion is not easy to know.

Construction Contracts Best Practices

While there are different types of construction projects, the contracts follow the same rules and have pretty much the same elements. Here are the best practices when writing construction contracts:

• Incentives are helpful when the scope is not very clear, and the budget or costs of the project are not yet determined.
• The parties need to agree on defining costs, especially in the cost-plus contract. Will redoing the rejected work be part of the overall costs included in the total bill? What about the contractor’s equipment? What rate will be applied?
• How and when will there be communication between the client and the owner? Both parties should know when and how to contact the other before making decisions.
• Parties should agree on how to apportion any savings from the project. Will all the savings in the cost-plus method go to the contractor?
• Since every project may have unforeseen circumstances, it is vital to accommodate contingencies. It is much easier for the project when there is a roadmap in place if something unplanned happens or there is an unexpected expense.
• State the expectations clearly, such as the method of reporting the expenses.

Knowledge of the different types of contracts, their advantages, and their disadvantages is crucial, and it helps to know which one to choose to align with a particular project.

Contact us to discuss your constructions contract needs.