There are several types of construction contracts, where each one is designed to deal with a different customer requirement. By knowing the contract options, the contractor and customer can select the best option to match their needs and manage risks. The main types of construction contracts are fixed price, cost plus, and unit-price. The features of each contract type are as follows, with variations from the basic concepts also noted.

Fixed Price Contract

Under a fixed price contract, the price to be paid to the contractor is fixed in advance. A contractor only accepts this type of contract when costs can be reliably estimated and the contractor has experience with this type of work. If there is any uncertainty regarding costs to be incurred, the contractor submits a high bid in order to ensure that it still earns a profit. An advantage of fixed price contracts is that finishing under budget can result in a substantial profit. However, every variable must be included in the contract, or else the contractor will be at risk of losing a substantial amount if any problems arise.

Cost Plus Contract

Under a cost plus contract, the price to be paid consists of reimbursement for costs incurred, plus a profit percentage. This contract shifts risk to the customer, which bears the burden of cost overruns, and is used when the contractor is uncertain of the costs to be incurred or does not have a large amount of experience in this type of work. Variations on the concept are:

Guaranteed maximum price. The total amount paid by the customer is capped, so the customer bears the risk of cost overruns up to the cap, after which the contractor bears the risk. The cap amount may be adjusted with a change order if the project scope changes.
Cost plus fixed fee. The contractor earns a fixed amount of profit, which removes the incentive to keep adding expenses on which a profit percentage is paid.
Cost plus performance incentives. The contractor can receive bonuses for meeting certain objectives, usually involving more rapid completion of a project.

Contractors generally prefer cost plus contracts, since the risk of cost overruns is shifted to the customer. However, a contractor may prefer a fixed price contract when it understands the risks and can build a substantial profit into its price.

Time-and-Materials Contract

A time-and-materials contract is a variation on the preceding cost plus contract. Customers are billed a standard hourly rate per hour worked, plus the actual cost of materials used. The standard labor rate per hour being billed does not necessarily relate to the underlying cost of the labor; instead, it may be based on the market rate for the services of someone having a certain skill set, or the cost of labor plus a designated profit percentage. If the contractor chooses to base labor rates on their underlying costs, rather than the market rate, it can do so by adding together the following:

The cost of compensation, payroll taxes, and benefits per hour for the employee providing billable services.
An allocation of general overhead costs.
An additional factor to account for the proportion of expected unbillable time.

The cost of materials charged to the customer is for any materials actually used during the performance of services for the customer. This cost may be at the contractor’s actual cost, or it may be a marked-up cost that includes a fee for the overhead cost associated with ordering, handling, and holding the materials in stock.

Time-and-materials billings are useful in situations where the outcome of the work is in such doubt that the contractor will only take on the work if it can be properly reimbursed. Also, if the contractor can keep its employees billable, then this pricing structure makes it difficult not to earn a profit. However, customers may recognize that this approach will allow the contractor to potentially run up its hours billed, so they tend to push back by putting a cap on the total price, or by negotiating reductions in the billable rate per hour and eliminating any mark-ups on materials.

Unit-Price Contract

A unit-price contract is an arrangement in which the client pays a specific price for each unit of output. This arrangement is rarely used in a large, complex construction project where there are few units of output that are easily replicated. For example, a client is unlikely to demand a unit-price contract for each of a cluster of apartment buildings. However, the general contractor may use this type of contract with its subcontractors for selected work arrangements. For example, a general contractor for the construction of a road could enter into a unit-price contract that pays a certain amount per square foot of sidewalk installed.