5 Construction Billing Methods & When to Use Them

One of the most important aspects contractors agree to when signing onto a project is how and when they will get paid — or, in other words, the billing method. How contractors bill for their work impacts a construction project’s schedule, financial standing, and the odds of failure. Understanding which billing method works for which project can be a critical factor to its success. 

This article will compare the most common construction billing methods, which projects best suit each — and suggest some billing best practices to help get contractors paid on time.

Popular Methods of Construction Billing

Construction billing always refers back to the contract terms that dictate how contractors will charge for their work. Below are some of the most common billing methods used in the industry.

1. Lump Sum

When using lump sum billing, contractors and owners agree to the owner's total project cost before any work begins. The contractor invoices the owner at set intervals throughout project completion — say, once a month or at specific milestones — but because the project's total price remains the same, the contractor may not have to produce many backup documents showing line-item costs and profits.

When to Use Lump Sum Billing

Contractors and their administrative staff may prefer lump sum billing regardless of project size because of the freedom and time-savings it provides. Owners who are not that familiar with the contractor may prefer a more open-book billing method that allows them to see what costs and profits there are for the contracted work.

2. Cost-Plus

Cost-plus contracts involve the contractor billing the owner for each cost that goes into the project, as well as a fee to cover the contractor's overhead and profit. The fee may be calculated as a percentage of the total contract cost or a fixed fee set at the beginning of the project. Owners may offer contractors financial incentives to keep costs low to minimize the uncertainty of cost-plus contracts.

When to Use Cost-Plus

Cost-plus works best with large contracts for owners who want to understand all of the costs going into their construction projects and projects that are difficult to estimate because the scope is not entirely clear at the outset.

3. Time and Materials (T&M)

As the name suggests, time and materials billing invoices owners based on the number of labor hours on the project and the cost of the materials. In a  time and materials contract, the contractor includes profit margins in the hourly prices quoted to the owner and the exact scope of work is not clearly defined or is expected to change.

When to Use Time and Materials

Time and materials billing is used for small contracts and self-perform work. Subcontractors and self-perform general contractors could each use this method. A GC who contracts a great deal of work to subcontractors could use a partial or hybrid time and materials billing for the self-perform work with not-to-exceed limits in place, while using lump sum contracts for each subcontractor.

4. Unit Pricing

Unit pricing is a method contractors can use to boil down project prices into blocks of work and then charge for each block (or unit) they complete. For instance, a contractor may charge per cubic yard of concrete. Unit pricing can be used in combination with any other billing method to get really granular with costing by detailing hours of work, cubic footage of concrete, and the equipment used.

Alternatively, contractors can bundle labor, material, overhead, and profit all into a single unit and charge by that unit.

5. Guaranteed Maximum Price (GMP)

A contractor using guaranteed maximum price billing sets an upper limit to the cost of completing a construction project. Unlike lump sum billing, which allows contractors to keep additional profits if they manage to complete a project cheaper than expected, GMP billing allows the customer to keep the savings. In this way GMP can be seen as a medium ground between lump sum and time and materials billing.

When to Use GMP

Guaranteed maximum price contracts are good for projects that the contractor knows well and has experience with. Projects should have a clearly defined scope to minimize the financial risk for the contractor. GMP can be very attractive to owners who have limited budgets.

Adding in a Contingency Fund

Some contracts allow for a contingency fund to be set aside to cover unexpected costs throughout the project. By using a contingency fund, the contractor can cover the costs of some changes to the original scope of work.

Some contracts that include contingency funds include stipulations as to their usage, including things like

• Incentives for the contractor not to use them, like an offer to split the fund if the contractor keeps the costs down
• A definite limit, after which the owner will pay no more toward the project's completion

A set contingency fund creates a sort of mixture of a fixed price contract, but with wiggle room for the unexpected.

Best Practices for Construction Billing

Newer contractors may go into a project believing they have an understanding with project owners about how to bill, only to find out that the contract or other stakeholders require more detail before payments will be approved. It's important to read and fully understand the requirements for each billing to maintain good financial health on the project.

Understand the contract terms.

Contractors and owners should always ensure they fully understand the contracts they sign. This includes reading the entire contract and comprehending the billing method outlined in it — including what kind of record keeping and administration will be required to apply for payments.

Align the payment terms.

Depending on contract stipulations, payment terms may allow for 30, 60 or 90 days between billing and payment. General contractors should ensure that whatever payment terms they receive are mirrored in the contracts with their subcontractors. Having to pay a subcontractor within 30 days when a progress payment may not come for another two months could impact cash flow and prove detrimental to the project as a whole.

Know the parties involved.

Contractors should understand all of the stakeholders involved on a construction project. While owners and contractors may agree on billing practices, lenders, investors, or third-party managers may have their own stipulations that contractors will need to meet in order to get paid.

While some owners manage all the project billing on their own, others will bring in architects or a construction manager who will handle billing for them. A third party reviewing the billing may necessitate an onsite review of the work done to date.

Financiers can change the billing process a great deal. If a bank is involved in funding a project with an owner, the bank may have far more stringent payment application requirements that the owner may not even be aware of. The bank may put an unexpected stop on construction payments because billing requirements haven't been met, leaving the GC with interrupted cash flow and spelling disaster for the project.

Manage your documents.

There is a lot of admin work involved in billing, especially when using cost-plus and T&M billing methods. It is time-consuming to pull a bill together. Contractors should establish a documents process to collect backup materials for every billing and organize them together. Without a solid system for managing receipts, photos, and drawings, office staff can become overwhelmed and miss payment application deadlines, which can seriously impact project finances.

Ask for examples.

When working with an owner for the first time, it can be difficult to understand what's required for billing. If in doubt, ask questions about exactly what documents need to be included, or ask for an example of a payment application from a previous project.

With any luck, billing will be straightforward, including submitting pay applications, invoices, receipts and lien waivers. However, it's the contractor's responsibility to understand what backup documentation is required to keep payments coming.

Establish a kickoff call.

Getting everyone together to discuss billing at the beginning of a project is enormously helpful. Ask to meet with all stakeholders, from the owner to the lender to the construction manager to fully understand what each requires.

Ask what backup documentation is required for something like change orders, which can be very complicated to bill. If the contractor hasn't collected all the paperwork to be reimbursed for a change order, months could go by, the contractor has already paid the subcontractor and the sub has moved onto another job, and the paperwork the contractor needs becomes very difficult to get.

Billing for Success

Keeping up with billing throughout the project cycle will avoid chasing down documentation from long-finished tasks and cover all the bases for backup documentation.

Construction billing can be complex and time-consuming, but the very health of a construction project depends on getting it right. Establish a billing method that suits the project, understand the documentation expected for each billing, and attempt to marry billing periods between upper-tier and lower-tier contractors for optimal cash flow and project success.

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