Lump-Sum Contract: Meaning, Advantages, Disadvantages and More

Lump-Sum Contract: Meaning

A lump-sum contract is a legal contract where the contractor promises to complete the whole project at a pre-agreed price. In other words, the contractor is responsible to complete the whole task at a mutually agreed price, in such type of contract. Here the focus is on the completion of the whole project and not on the smaller tasks. The contractor doesn’t ask the client to pay for smaller tasks, instead asks to pay a lump-sum amount for the whole task.

On the basis of the nature of the project, the contractor estimates the total cost of the project. The contractor has to be very optimal at the time of estimating the cost of the project. In the computation of lump-sum cost, consideration of labor cost, material cost, overheads costs along the profits margin takes place. Mostly, the client makes the total payment in small installments in a staggered manner to the contractor.

A lump-sum contract works best when the scope of the project is narrow and predefined. This contract is not useful when there are many dimensions and multistage innovations to the project. When the project is straightforward, the lump sum contract serves its best. The contractor under this type of project, mostly charges mark-up prices, for bearing the risk of any future unforeseen situations.

The lump-sum contract is also known as a stipulated sum contract or fixed-price contract.

Understanding Lump Sum Contract

A lump-sum contract is one of the very popular construction contracts. The contractor has to decide on the design of the project, even before the construction work begins for the project. Mostly under this type of contract, the construction project is mediocre and predictable in nature. Because of the simplicity of the project, it becomes easy for the contractor to estimate the lump-sum cost of the project. Although, the estimated lump-sum cost can fluctuate due to various elements.

These elements are as follows:- 

There could be variations in the nature and type of the project work, natural and/or man-made events can fluctuate the set price, Inflation can also impact the lump-sum price, prices can fluctuate due to non-consideration of few payments to the external party, changes in the statutory fees or commission can also lead to variation, increase or decrease in the prices of inputs (raw material), etc.

Advantages

  • Under the lump-sum contract, the client of the project faces very little amount of risk.
  • This contract has a minimal amount of variations. Mostly the target, the inputs, and the outputs, everything is fixed.
  • In such types of contracts, the client is fully aware of the total cost and scope of the project even before the beginning of the project. And therefore it becomes easy to manage the sources of finance timely, by the client.
  • The cash flows for the contractor and the client is mostly predictable.
  • The whole process of tender is very transparent and clean in nature.
  • It becomes easy to avail construction loan, on the basis of a lump-sum contract.
  • There are high chances of higher profit margins for the contractor, under this type of contract.
  • The bidding process and the selection process are very crystal clear under the stipulated sum contract.
  • The time of the client is saved because of less supervision required.
  • This contract reduces the overhead expenditures, on the contractor’s side also.

These advantages are non-exhaustive in nature.

Disadvantages

  • Lump-sum contract doesn’t work where the project is complicated in nature.
  • Lump-sum contracts are not suitable for speedy projects.
  • Under this type of contract, the contractor faces a very high amount of risk. The contractor mostly has to complete the project within the set price. Therefore his estimation has to be near perfect, else it may land him in losses.
  • Sometimes, the cost of preparing a tender for the contract is even higher than the actual cost of the project.
  • These contracts may have high chances of disputes between the contractor and the client if the scope of work is not well spelt out.
  • The requirement of precise documentation under this type of contract may sometimes become a time-consuming task.
  • Such contracts become expensive if the client is constantly modifying or adding structures to the existing model. The contractor charges an additional price for each such kind of addition or modification.
  • Under this type of contract, the contractor selects the construction method, according to its own convenience. The client may not have enough say in this situation.
  • Conflict of interest can occur between the contractor and the client. The focus of the client is to generate as much as productivity out of the total money spent. Whereas, the focus of the contractor is to generate as much profit as possible.
  • There high chances of quality deterioration, because the contractor has to finish the job at the set price.

These disadvantages are non-exhaustive in nature.

lump-sum contract

Lump-Sum Contract Vs Cost Plus Contract

Both these contracts are types of incentive contracts. There are a few differences between a cost-plus contract and a stipulated sum contract, they are as follows:- 

In a cost-plus contract, the client pays all the costs (including fixed, variable, and overheads) and additional fees/margin to the contractor. Unlike, the lump sum contract, where payment of the approximate amount takes place. There is a high possibility of more profit generation in the stipulated sum contract in comparison to the cost-plus contract. In a lump-sum contract, it is compulsory to have proper designs and structures before the beginning of the construction project. In the case of a cost-plus contract, it is not compulsory to do the same. An increase and decrease in the cost of the project will impact the profits in the stipulated sum contract and not in the cost-plus contract.

A cost-plus contract requires a lot of documentation in comparison to a lump-sum contract. Constant watch, changes, follow-up, and differences in cost because of each and every modification/additional work need to be recorded by both parties in detail at each stage to avoid any dispute at later date.

Lump-Sum Contract Vs Unit Price Contract

There are a few differences between unit price contract and stipulated sum contract, they are as follows:-

Unit price contract is a broader concept in comparison to lump-sum contract. A unit price contract is a combination of many lump-sum contracts altogether. Lump-sum contracts are not that flexible in nature, while the unit price contracts are flexible and deal with multistage projects. The cost of the project mostly stays the same in the stipulated sum contract, but in the unit price contract with the increase in units, the cost also increases.

Conclusion

There are many disadvantages of the lump-sum contract. All these disadvantages can be overcome if the project is well-defined and structured in nature. A solid and basic construction design (drawings), mediocre construction structure, and foolproof documentation are the best-supporting scenarios for a lump-sum contract. This contract reduces the risk on the side of the contractor and allows the contractor to earn high-profit margins. This is also beneficial for the client as everything about the project – cost, structure, timeline, funding, etc remains crystal clear for him. And there remains a lesser effort on account of supervision, validation, and recording of the details. Thus using a lump-sum contract in selective projects gives outstanding results.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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