The Wrong Contract Will Ruin Your Project
How Developers Can Choose Construction Contracts to Optimize Outcomes and Minimize Risk
Selecting an appropriate construction contract is a critical decision often undervalued by developers. While substantial effort is typically invested in budgeting, scheduling, and design, the contractual framework that underpins these elements is frequently treated as a routine, administrative detail. In reality, improper contract selection can quietly but dramatically erode budgets, amplify risk, and undermine the financial viability of an entire project.
This week, we explore how seemingly minor differences in contract types—such as Stipulated Sum (Fixed Price), Cost-Plus-Fee arrangements (with or without a Guaranteed Maximum Price), and Design-Build contracts—can substantially influence project outcomes. Each contract type allocates risk and responsibility differently between the owner and contractor, directly impacting financial control, project quality, and overall risk exposure.
By deeply understanding the mechanics, advantages, and potential pitfalls of these contract structures, developers can make informed, strategic choices that minimize disputes, enhance financial predictability, and promote successful project completion.
Understanding the Mechanics of Contract Types
Each construction contract type uniquely allocates project risk, defines financial controls, and establishes protocols for managing scope, costs, and changes. Clearly understanding these fundamental differences and their practical implications enables developers to strategically select the optimal contract framework aligned with their project's specific needs, objectives, and risk tolerance.
1. Stipulated Sum
Under a Stipulated Sum (often called a Fixed Price or Lump Sum) agreement, the general contractor commits to delivering a clearly defined project scope for a predetermined, fixed amount. This contract structure can offer significant benefits, including budget predictability, reduced administrative overhead, and strong incentives for contractors to manage costs efficiently. It transfers the primary risk of cost overruns to the contractor, provided the scope remains well-defined and stable.
However, the effectiveness of this contract depends entirely on clear documentation, appropriately defined allowances (predetermined cost placeholders for items not yet fully specified) and carefully structured contingencies (funds set aside for unexpected expenses). Poorly defined scopes or unrealistic estimates for these items can quickly undermine the stability and cost control this contract promises.
Key Features:
Cost Certainty: The contractor commits to delivering the defined scope at a fixed, predetermined price, providing clear financial expectations for the owner.
Contractor Risk Assumption: Cost overruns, excluding approved changes, are absorbed by the contractor, incentivizing precise cost estimation and careful project management.
Minimal Owner Oversight: Clearly defined specifications and allowances enable reduced owner involvement in ongoing cost management.
Detailed Documentation Required: Complete and detailed project documentation must be finalized before contract execution to prevent disputes and ambiguities.
Real-World Example:
I was brought in midway through the construction of a $20 million spec home in Bel Air that was severely impacted by escalating costs and ongoing disputes. Structured under a Stipulated Sum contract, the project was already millions of dollars over its original budget, with change orders rapidly accumulating.
Upon closer examination, two critical issues emerged. First, the project’s construction documents had been prepared without specifying interior finishes or fixtures, an attempt by the developer to reduce upfront design costs by selecting materials himself "later." As a result, the contractor's budget allowances reflected more modest-level finishes (think Kohler and Daltile), while the developer had anticipated high-end, luxury-quality Dornbracht fixtures and Ann Sacks tile. Additionally, no landscape architect had been engaged, leaving that scope undefined and underestimated.
Second, the GC's schedule of values did not include a contingency line item, leaving no cushion for unforeseen expenses or scope adjustments. These inadequately defined budgets were quickly depleted, driving significant cost overruns, continuous disputes, strained relationships, and ultimately stalling construction progress.
When a Stipulated Sum Contract Works Well:
When project documentation, including finishes and fixture selections, is meticulously detailed and finalized prior to contract execution.
When all budget allowances and contingencies clearly align with the developer’s quality expectations and project scope.
When every project element, such as landscaping, is accounted for within professionally developed, realistic budget parameters.
Common Pitfalls to Avoid:
Initiating construction without finalized material selections, leading to ambiguity, conflict, and budget overruns.
Employing allowances that underestimate the intended quality of materials, causing financial strain and continuous disputes.
Omitting contingency line items from contractor budgets, significantly increasing the risk of unmanageable cost escalation.
A properly managed Stipulated Sum contract provides significant cost predictability and risk management, but only when all finishes, allowances, contingencies, and scope elements are explicitly defined and agreed upon upfront. Anything less risks ambiguity, escalating costs, and persistent disputes.
2. Cost-Plus-Fee Without a Guaranteed Maximum Price
A Cost-Plus-Fee contract, without the protection of a Guaranteed Maximum Price (commonly referred to as Cost-Plus) obligates the owner to pay the contractor’s actual incurred costs plus an agreed-upon fee or percentage for overhead and profit. This structure provides substantial flexibility, particularly suitable when design documentation is incomplete, or when the project requires significant customization and ongoing design evolution. Often, the contractor provides a "Control Estimate"—a non-binding projected cost used to guide budgeting and cost tracking—yet the owner remains exposed to actual costs incurred without an upper limit.
When managed effectively, this contract fosters transparency, promotes close collaboration, and accelerates early construction phases. However, without a Guaranteed Maximum Price (GMP), it exposes the owner to substantial financial risk, emphasizing the critical need for rigorous oversight, clear cost-reporting, and explicit management protocols.
Key Features:
Budget Flexibility: Owner reimburses the contractor for actual incurred costs plus an agreed-upon fee, allowing adjustments for evolving designs and scope changes.
Transparency: Detailed and transparent reporting of all project costs fosters trust and collaboration between owner and contractor.
Owner’s Risk Exposure: Without a cost ceiling, the owner bears the full risk of cost escalation, highlighting the importance of rigorous oversight and management.
Adaptive to Complexity: Ideal for projects where specifications and designs are incomplete or continually evolving, providing necessary flexibility throughout the construction process.
Real-World Example:
I was engaged midway through construction as the Owner's Representative on a high-profile historic home restoration project in Southern California, originally budgeted north of $10 million under a Cost-Plus arrangement due to incomplete construction documents and the need for ongoing design decisions to meet the owner's aggressive schedule demands. Initially, this flexibility enabled construction to begin swiftly, accommodating evolving design elements and highly customized details.
However, within months, the budget spiraled out of control. The owner and their team had mistakenly approached the contract as if it were Stipulated Sum, assuming that the initial Control Estimate represented a fixed total cost. Rapid, frequent owner-driven design changes, such as elaborate custom millwork, premium imported finishes, and historically authentic glazing, occurred without clear approvals or cost tracking, quickly accumulating into hundreds of thousands of dollars in unanticipated costs.
Additionally, the lack of detailed documentation and explicit approval processes led to continuous disputes over contractor billings. Contractors argued costs were legitimate and necessary, while the owner perceived these charges as unjustified and inflated. Relationships deteriorated rapidly, and construction slowed dramatically due to these persistent financial disagreements.
When a Cost-Plus Contract Works Well:
Early project phases where complete designs and detailed specifications are not yet finalized.
Highly customized, complex, or historic restoration projects requiring continuous flexibility.
Situations involving robust trust, disciplined cost-tracking, transparent approvals, and active owner involvement.
Common Pitfalls to Avoid:
Misinterpreting the Control Estimate as a binding fixed cost, creating unrealistic expectations and severe financial friction.
Lack of explicit cost-reporting, tracking, and approval procedures, causing confusion and mistrust.
Inadequate oversight of evolving scope and costs, resulting in rapid and uncontrolled budget escalation.
When clearly understood, Cost-Plus contracts offer substantial flexibility. However, without strict management, clear protocols, and precise stakeholder alignment, they carry substantial financial and relational risks.
3. Cost-Plus-Fee With a Guaranteed Maximum Price
A Cost-Plus-Fee arrangement with a Guaranteed Maximum Price (commonly referred to as GMP) provides a balanced hybrid approach by combining the transparency and flexibility of a Cost-Plus model with the budget certainty offered by a stipulated ceiling. Under this contract, the owner reimburses the contractor's actual costs plus a predetermined fee, but with an agreed-upon maximum limit. While this GMP provides essential cost protection, total project expenses can still exceed this amount if additional costs arise from explicitly agreed-upon scope changes, typically becoming the owner's responsibility. However, any unapproved or unforeseen expenses beyond the GMP are usually absorbed by the contractor, offering a critical safeguard for the owner.
Key features:
Cost Savings Incentives: Encourages contractors to identify and implement cost efficiencies, as savings below the GMP are generally shared between owner and contractor. This incentive aligns interests and fosters proactive management.
Open-Book Buyout Process: Utilizes transparent bidding and selection of subcontractors, promoting competitive and fair pricing through full visibility into procurement practices.
Clearly Defined Contingency: A specific contingency allowance within the GMP covers unforeseen or unexpected costs. However, without explicit guidelines for contingency usage, disputes can arise, potentially jeopardizing collaboration and cost certainty.
Real-World Example:
A 10-story multifamily adaptive reuse project in Los Angeles, where I served as the construction manager, employed a GMP structure with clearly documented contingency management guidelines and a fully transparent subcontractor selection process. This structured approach allowed both the developer and contractor to closely scrutinize bids and manage expenditures collaboratively throughout the project. Upon completion, the disciplined oversight resulted in approximately $250,000 in shared savings, underscoring how clear contingency guidelines, transparent procurement practices, and aligned financial incentives can significantly enhance project profitability and team collaboration.
When a GMP Contract Works Well:
Projects with moderately complete design documentation, allowing realistic pricing while accommodating minor design adjustments.
Situations with transparent and trust-based owner-contractor relationships that enable disciplined collaboration and cost management.
Clearly structured financial incentives encouraging efficient construction practices and proactive management.
Common Pitfalls to Avoid:
Ambiguous contingency guidelines or unclear approval processes causing disputes and eroding stakeholder trust.
Insufficient oversight of subcontractor bids and procurement processes, risking inflated costs and misuse of contingencies.
Aggressive GMP negotiations resulting in unrealistically low budgets, leading to contentious cost management and diminished project quality.
When executed properly, a GMP contract balances flexibility with cost certainty, fostering proactive management, financial transparency, and collaborative stakeholder relationships. Ensuring clear contingency guidelines, transparent cost management, and realistic budgeting upfront is essential to harnessing the full benefits of this contractual approach.
4. Design-Build
In a Design-Build arrangement, a single entity—the contractor—is responsible for both the design and construction of the project under one unified contract. This streamlined model offers owners significant advantages in efficiency and accountability, as the entire project delivery process is managed by one integrated team, eliminating traditional gaps between design and construction phases. However, this approach inherently limits the owner's direct control over design details, necessitating clearly defined performance criteria from the outset.
Key features:
Single Point of Contact: The owner benefits from having one primary point of contact responsible for the entire project, simplifying communication, decision-making, and accountability.
Accelerated Schedule: With design and construction activities overlapping or occurring simultaneously, the Design-Build approach significantly reduces overall project timelines, providing substantial schedule benefits.
Reduced Owner Control: Owners must explicitly articulate performance and quality requirements upfront, as detailed specifications are typically minimal at contract signing. Precise and early communication of expectations is critical.
Unified Design Responsibility: The Design-Build contractor assumes complete accountability for both design quality and construction execution. Selecting the right team is essential to ensuring alignment with aesthetic preferences, functional outcomes, and quality expectations.
Real-World Example:
Our design-build group managed an extensive, multimillion-dollar residential renovation and expansion project in Los Angeles for a prominent entertainment industry client. Due to the client’s schedule demands, a highly compressed timeline was essential, necessitating overlapping design and construction phases. Clear performance criteria and a detailed architectural program were established early, including spatial layouts, privacy standards, energy efficiency targets, and specific aesthetic outcomes, such as high-end custom cabinetry, bespoke lighting solutions, and specialized interior finishes.
Key quality benchmarks included achieving precise sound isolation standards between critical spaces, integrating custom architectural millwork seamlessly, and meeting rigorous energy performance metrics through advanced insulation and HVAC systems. By clearly defining these benchmarks and providing structured yet flexible guidelines for material and layout decisions, the contractor team efficiently balanced creative solutions with the client's specific expectations. This disciplined approach shaved approximately four months from the original project timeline, substantially reduced carrying costs, and delivered a high-quality finished product aligned precisely with the client's vision.
When a Design-Build Contract Works Well:
Projects with aggressive or compressed schedules where timeline risk mitigation and accelerated delivery are crucial.
Situations where the owner can explicitly define performance requirements and desired outcomes early in the process.
Projects benefiting from strong trust and collaboration between owner and contractor, facilitating streamlined and decisive project execution.
Common Pitfalls to Avoid:
Vague or incomplete performance criteria leading to misunderstandings, design misalignment, or disputes over project outcomes.
Selecting a Design-Build contractor without thoroughly assessing their proven capability in both design management and construction execution.
Underestimating the required oversight, assuming minimal owner involvement instead of actively managing and verifying adherence to clearly defined performance standards throughout project delivery.
When properly executed, a Design-Build contract can significantly streamline project timelines, reduce carrying costs, and foster collaborative teamwork. Clear initial communication, precise performance criteria, and active owner oversight are essential to leveraging the full benefits of this integrated approach.
Practical Considerations for Strategic Contract Selection
Selecting the optimal construction contract begins with a thoughtful assessment of your project’s unique characteristics and your organization's risk profile. Before choosing your approach, carefully evaluate these fundamental considerations:
Scope Clarity and Completeness.
Does your project have a fully developed scope with clearly documented design details, or do you anticipate significant design evolution and scope adjustments during construction? Aligning your contract type with the maturity of your project's scope is essential for mitigating unexpected costs and conflicts.
Example: Stipulated Sum contracts are ideal for projects with fully developed designs, such as a custom single-family home with finalized plans. Conversely, a Cost-Plus or GMP model would better suit an adaptive reuse multifamily project undergoing extensive design refinements mid-construction.
Risk Tolerance and Cost Predictability.
Consider how comfortable your organization is absorbing project cost fluctuations and uncertainty. Contracts that transfer cost risk to the contractor, such as Stipulated Sum, demand fully developed designs, whereas Cost-Plus models require greater oversight but allow more design flexibility.
Example: A conservative investor seeking maximum cost predictability on a straightforward retail build-out may prefer a Stipulated Sum. Alternatively, an investor developing a complex historical renovation project with unpredictable scope elements might benefit from a Cost-Plus arrangement, accepting higher risk for greater flexibility.
Schedule Urgency and Timeline Requirements.
Does the project timeline justify overlapping design and construction activities, or do you have sufficient lead time for a traditional sequential approach? Design-Build and GMP contracts can significantly shorten schedules but require detailed upfront planning to succeed.
Example: Design-Build is suitable for a hospitality project where opening dates are critical to revenue and accelerated construction timelines provide significant financial advantages. In contrast, a high-end residential development with no immediate timeline pressures might better align with a traditional sequential contract.
Project Team Alignment and Experience.
Assess whether your project team—including owner, architect, contractor, and key advisors—has the collective experience and skills required to effectively manage open-book financial structures, contingencies, and collaborative project models. Contracts demanding transparency and collaboration (GMP, Cost-Plus, Design-Build) require seasoned oversight and clear processes.
Example: A sophisticated project team experienced in collaborative delivery models would thrive under a GMP or Design-Build arrangement on an adaptive reuse office-to-multifamily conversion. Conversely, an owner with limited construction management experience might benefit from a straightforward Stipulated Sum contract on a clearly defined commercial retail project.
Best Practices for Contract Negotiations
To proactively avoid costly pitfalls and conflicts, incorporate these best practices into your contract negotiation and selection process:
Clearly Define Allowances and Contingencies.
Provide explicit, detailed descriptions of all allowances and contingencies, supported by realistic budget estimates. Clearly document how these allowances will be managed, authorized, and adjusted during construction to ensure transparency and minimize misunderstandings.
Establish Transparent Cost Management Procedures.
Define clear, consistent procedures for cost tracking, reporting, and approval—particularly critical for Cost-Plus and GMP arrangements. Set standardized and transparent rates for potential Time-and-Material (T&M) tasks upfront to control costs effectively and prevent unexpected overruns.
Conduct Rigorous Bid Analysis and Contract Review.
Perform detailed bid analyses, carefully reviewing each bidder's assumptions, exclusions, and qualifications. Engage experienced legal and construction management professionals to thoroughly evaluate contract language and risk allocation, ensuring alignment with project goals and your organization's risk tolerance.
Maintain Proactive Communication and Comprehensive Documentation.
Implement consistent communication protocols and thorough documentation standards from project initiation through completion. Comprehensive documentation helps prevent disputes, fosters transparency, and supports effective decision-making throughout the project lifecycle.
Final Thoughts
Selecting the optimal construction contract goes far beyond administrative or legal formality. It's a strategic decision that significantly shapes project outcomes, influences financial predictability, defines team dynamics, and determines overall risk exposure. Thoughtful and informed contract selection safeguards budgets, aligns stakeholder interests, and enhances project efficiency.
Never delegate or underestimate this crucial step. Thoroughly understand each contract type, its operational details, and strategic implications. Make informed choices aligned specifically with your project's requirements and your organization's overarching goals. Investing the necessary time and effort into strategic contract selection consistently yields smoother project execution, fewer disputes, and improved financial and operational results.
Disclaimer: This newsletter provides general educational information and should not be considered legal, financial, or professional advice. Always consult qualified legal and construction professionals for guidance specific to your project.
Hi Ted, thanks for your post! Contracts are incredibly important and I have found there is often confusion about the nuances of GMP contracts in particular.
With regards to GMP contracts, would you be able to speak to the timing of when GMP contracts are executed? As I understand it, the timing of when the GMP is negotiated and can vary depending on the project, level of document detail, schedule, etc. What are the parameters and risks to consider?
Do you consult on construction contracts?