Types of Contracts: Learn About 3 Main Types

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What Is a Contract?

A contract is a legally binding agreement between two or more parties who agree to buy or sell goods and services from one another. There are many different types of contracts. The three most common contract types include:

  • Fixed-price contracts
  • Cost-plus contracts
  • Time and materials contracts

A contract provides legal protection for all parties involved in the transaction. It outlines the rights and responsibilities of all parties and helps reduce the risk of any party forfeiting their duties per the agreement. Contracts typically include details related to the scope of work of the project, quality control, legal jurisdiction, project schedules, and payment terms.

A contract is fundamental to any business transaction that involves an exchange of value. It documents the terms of the agreement in a way that is enforceable in a court of law if any party does not hold up their end of the exchange.

Understanding Different Types of Contracts

Before taking on a project, vendors, contractors, and other types of sellers gather certain details about the project to create an estimate for the labor and materials required to complete the project. In some cases, buyers give a very detailed description of their needs. However, buyers sometimes do not know exactly what they want or need. Different situations require different types of contracts.

Since contracts come in many forms, each with its own purpose and use, it is important for business owners to understand the different types of contracts and select the best one for each transaction.

Fixed-Price Contracts

Fixed-price contracts are also known as lump-sum contracts. This type of contract is ideal in situations where there is a clearly defined scope of work. In such cases, the buyer provides a detailed description of the final outcome, including product dimensions, expected timeframes, material specifications, and more. Here is an article about how to write a scope of work .

Using the information provided by the buyer, the seller creates a formal statement of work that outlines the total project cost, including all labor and materials, along with billing milestones based on a detailed project schedule. If the buyer makes any changes to the scope of work or timeline, it can mean additional charges from the seller.

With fixed-price contracts, buyers know the exact cost of the project from the start, which many people see as a big benefit. Fixed price contracts result in a minimal risk for buyers. While buyers sometimes make a lump-sum payment at the start of the project, the seller takes on the majority of the risk since the buyer often only pays for work once it's completed.

If the project takes place over a longer timeframe, buyers usually make smaller lump-sum payments at specific project milestones. For example, construction crews typically charge a fixed price for all materials, labor, and equipment. They receive payment upon completion of each stage of the construction project.

With fixed-price contracts, sellers cannot go back to the buyer to ask for more money if they go over budget. As a result, sellers take on the majority of the risk, so they sometimes pad the price to make sure they cover any potential risks.

If something goes wrong and sellers underbid the original contract price, they risk eating into their profit and must find ways to cut corners and decrease costs. Project quality and schedules can suffer as a result. Also, if buyers pay any money at the start of the project and the work remains incomplete, getting the money back is sometimes a challenge.

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Cost-Plus Contracts

With a cost-plus contract, also known as a cost-reimbursable contract, buyers pay for the cost of the work plus a fixed percentage charged by the seller for providing the goods and services. Sellers charge the buyers for the actual cost of any materials, equipment, labor, and overhead involved in running the project. To make a profit, sellers tack on an extra fee based on the terms of the contract. Some sellers prefer an incentive payment option over a fixed percentage. Here is an article about how to structure an incentive contract .

A cost-plus contract defines all rates and percentages, as well as all allowable expenses and incurred costs. The contract often also includes a maximum amount sellers can spend. Any spending over that amount requires the buyer's approval.

With a cost-plus contract, neither the rates for materials and labor nor the quantity of time needed to complete the project is fixed. As such, costs may fluctuate throughout the life of the project. On top of that, buyers do not know the full cost of the project before it begins. Also, it is often difficult to track the actual effort and materials used for the project. Despite the uncertainties and risks to buyers, many prefer this option. In the end, they only pay for what they get, which many buyers view as an advantage.

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Time and Materials Contracts

A time and materials contract is great for buyers who don't necessarily know what they want when they begin their project. Sellers use time and materials contracts when it's difficult to determine the amount of time they need to spend on the project and the types of materials required to complete the project.

With this type of contract, sellers charge for the cost of any materials they end up using plus an hourly or daily wage. All rates, including any markup charges on materials and wages, are included in the terms of the contract. Once the contract is finalized and accepted, these rates stay in place for the duration of the contract.

For example, a time and materials contract works well for software developers hired to create an app for a company that is unsure about what the app needs to do. The developers charge for any time spent programming, designing, and testing the app, as well as any additional iterations required to finalize the product. They submit their receipts and records of working hours at fixed intervals as outlined in the contract to receive payment.

When sellers charge buyers based on time and materials, they typically keep a record of the time spent working on a certain project, as well as proof of any work they did during this time. This provides buyers peace of mind that their money is well spent. In some cases, sellers work directly as an extension of the buyer's team. This gives buyers considerable control over how sellers spend their time and the types of work they do.

Time and materials contracts work well for budget-conscious buyers. If they keep a close eye on the project costs, this type of contract provides an excellent way for buyers to enhance the skills on their team. However, a time and materials project poses a risk of blowing estimated costs if the project is not well managed.

Combining Different Types of Contracts

Sellers may combine different types of contracts to create one that hits all the high notes of their business exchange. Some business exchanges include a range of products and services, such as labor and equipment. In such cases, the contract needs to outline any applicable terms and agreements from more than one type of contract to cover all parts of the transaction, such as a fixed-price contract for the labor and a cost-plus contract for the equipment.

Understanding the different types of contracts and selecting the right one for the project is an important part of business transactions. It's often a good idea to work with a contract lawyer to make sure the contract holds up in court. As a rule of thumb, fixed-price contracts present less risk to buyers, while cost-plus contracts pose more risk to buyers. Meanwhile, time and materials contracts offer a more balanced risk for both buyers and sellers.

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