The 3 Ws of a Time and Materials Contract: What, When, and Why?
The whats, whens, and whys of time and materials contracts seem overwhelming.
They don’t have to be.
In this guide, we will go over the basics to get you started on time and materials contracts to help you feel more confident when using them.
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What Is a Time and Material Contract?
In short, a time and material contract (T&M contract) states that contractors will be reimbursed for the material costs and paid a set rate for time spent on the job.
The opposite is a fixed-price contract where the owner agrees to pay the contractor a lump sum to complete the contract when the payment does not depend on the resources used or time spent.
Keep reading to learn what is often found in a time and materials contract example and some pros and cons of using them.
How Is ‘Time’ Defined?
In a time and materials contract, time is defined in fixed hourly or daily rates. This can include:
- Wages
- Overhead
- General expenses and administrative expenses
- Profit for each category of labor
What Can ‘Material’ Include?
Materials can include:
- Supplies transferred between job sites or teams or between subsidiaries or other affiliates under the contractor’s central control.
- Subcontracts for supplies and incidental services when there is not a labor category specified in the contract.
- Other direct costs such as travel or computer usage charges.
- Other indirect costs.
Direct materials are those that enter directly into the end product and are consumed directly in making the end product or service.
What Should Be Included in a Time and Materials Construction Contract?
Each time and materials contract is unique.
Depending on the needs of the project, the contracts may look different, but many have similar elements. Here are some key parts that are commonly found in a time and materials contract template.
Unit Labor Cost
Unit labor cost defines how you structure the labor rate and can depend on what the customer wants.
For example, some owners may want a base labor rate with individual specialties broken down separately.
Labor Hours
The maximum number of hours is typically specified in T&M contracts.
If the contractor believes that the labor will run over that amount, the owner should be notified and a revised agreement signed.
Set Materials Markups
The customer usually pays retail pricing on materials used in the project. Sometimes the contractor has wholesale pricing with a supplier and can charge an additional material markup to the customer.
Time and materials contracts often cover brief time frames, so price protection for the contractor is less of a concern.
How and When to Report
Some owners may want daily reporting on the labor and materials cost of the project, while others are more flexible. Either way, specifying this ahead of time maintains the working relationship and gives accountants a schedule to work with.
With timely reporting, this running tally of expenses is more likely to be paid at the agreed-to time.
Billing Details
A billing and payment schedule will be mapped out in a T&M contract. Contractors want to be paid on time, and owners want to make sure the completed work meets their expectations before making a payment.
Clauses Covering “Not-to-Exceed” Guidelines
A not-to-exceed T&M contract includes an amount that is the maximum that can be charged by the contractor. This kind of contract means it's imperative that the contractor finish the project within a certain timeframe.
No matter how long the project takes or how high the materials costs run, the cap remains.
Revenue Recognition
When there is a cap on how much the customer will pay, this is the time to use revenue recognition for time and materials contracts.
It’s unusual to run revenue recognition for pure T&M contracts, but when you do, you’re typically telling your tracking system that you’re not earning as much revenue as you are billing.
Revenue recognition is a conservative approach to recognizing revenue and is similar to using a holdback on a fixed-price contract.
Advantages and Disadvantages of Time and Material Contracts
Every project is unique, so let’s take a look at some advantages and disadvantages of using T&M contracts.
Advantages
- Clear price structure
If something happens and the project goes longer than expected or the materials requirements change, having a simple, clear price structure means it's easy to move forward in the face of delays.
- Flexibility
You may need to vary the workloads or modify the scope of the project. If the scope is not clearly determined, a T&M contract gives you the flexibility you need to get the project done.
The project can proceed even when there is no definitive plan for how it will be completed.
- Negotiations
Negotiations can be simple if you:
- Have a T&M contract template,
- Plan ahead of time what materials you'll need covered; and
- Know what your labor rates will be.
Disadvantages
- Fronting expenses
One major drawback of T&M contracts is fronting your own costs. These contracts often work on a reimbursement basis where the contractor will purchase the materials in advance, then bill the owner later.
An owner might question the materials you've listed were actually used on the job. So this leads us to the next important point.
- Tracking time and materials
Paperwork. This pebble in the shoe of productivity is a necessary evil, but carefully tracking time and materials can help ensure that you get paid what you're owed and help prevent disputes.
- Little benefit to be efficient
If the payments are being made based on time and there is no not-to-exceed guideline in place, there is little benefit to finishing the job quickly.
This means the client may need to be more involved to make sure the contractor is motivated to stick within their time and materials budget.
- Negotiations
But wait. Wasn’t this an advantage?
Negotiating T&M contracts don’t always work out in your favor. Owners or clients may not agree on:
- Not-to-exceed conditions
- Labor costs per hour; or
- Mark-up of materials.
Negotiating so that everyone benefits may take some creativity.
When to Use Time and Materials Contracts
In construction contracts, contractors have two choices:
- Fixed-price contracts are used when the cost of the project is estimated and agreed upon before the work starts.
- Time and materials contracts are used when the cost of the project is based on an hourly rate of labor and the cost of materials.
When might a T&M contract be beneficial?
When a Project Is Unpredictable
A time and materials contract may help in the following situations:
- When the client doesn't have a clear picture of the end product
- The client hasn’t decided on many details of the project
- When there's no set timeline or the timeline has the risk of changing
When Project Flexibility Is Needed
T&M contracts give flexibility to the owners and the contractors. This is especially true in environments where change management is processed manually and can take several days to complete. Subcontractors aren't at risk for not getting paid for the work completed.
During longer projects, the need for flexibility increases because of the greater potential for the needs of the project to change. You may also need to account for overtime and longer work hours.
When a Subcontractor Is New to the Construction Industry
When you lack the time and experience, you run the risk of inaccurately forecasting what a project will take to complete.
New contractors may be unaware of:
- Hidden costs
- Expenses
- Overhead
- How much to markup materials
Without a system in place to accurately estimate cost, you may be unable to provide an accurate quote for the owner. A T&M contract may allow you some flexibility to gain this experience.
Why Can a Time and Materials Contract Be Risky?
Time and materials contracts can get risky.
Here are a few reasons why:
- T&M contracts are not legal in every State.
- According to the 2018 global construction disputes report, failure to administer contracts or poor understanding of compliance was the most common cause of disputes in North America throughout 2017. Without proper documentation and a clear contract, T&M contracts leave contractors open to dispute.
- You run the risk of being accused of not acting in good faith, which is breaking the law.
- Some clients closely monitor employee productivity, which can include the hours of work and breaks taken. Clients may be less willing to compensate for less visible work like mandated break times or time that’s spent for necessary conversations with employees.
- Clients may run out of money. When that happens, the client may try to blame you, and they may accuse you of lowballing your initial estimate.
How to Manage Time and Material Contracts
Let's take a look at what can be done to better manage T&M contracts to protect both the contractor and your client.
As a General Contractor
There are three fundamental dimensions of a project:
- Scope
- Cost
- Schedule
Try to rank these into first, second, and third in importance to see which dimension is least flexible. That way, you’ll understand the level of flexibility you’ll have with the other two.
Here are a few ways to better manage a T&M contract:
- Monitor productivity so you’re not paying for too much “downtime.”
- Include “not to exceed” guidelines that can benefit all parties.
- Include bonuses or other incentives to promote time-efficiency.
- Set clear expectations for every team member and have a clear process for how to execute the T&M contract.
As a Subcontractor
Ask for defined “not to exceed” guidelines so you can inform the customer when/if you’re getting close and find a solution.
Accurately tracking expenses is extremely important with T&M contracts.
Flexbase can help with that.
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