Common Types of Contracts

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In this post, let's talk about common types of contracts. A contract could be related to buying a product or buying a service.

KEY Takeaways

  • Common types of contracts are fixed price, cost reimbursable, and time & material contracts.
  • Fixed price contracts are often used in purchasing products and services.
  • Cost-reimbursable contracts are good for projects where the scope of work isn't known clearly.

To understand types of contracts, let's take an example of me getting my basement developed. For that, I need to look for a contractor who will develop the basement. The contractor will put walls around the basement, the window, lighting, and all those things, and then I will pay for that. So now, what type of contracts can I have in this case?

1. Fixed Price Contract

The first type of contract is fixed price. So what I will do is show the basement to my contractor. The contractor will take all the measurements. The contractor will do all the calculations of what it might cost to the contractor, giving me a fixed price.

Let's say the contractor tells me that the contractor will charge $20,000 to develop this basement, which will include these items. He will put these many lights, this type of flooring, this type of wall and so on. And there is a fixed amount I will pay to the contractor for all this work. That is a fixed-price contract.

The fixed-price contract could work in even buying something as well. If you want to buy a pump, nuts or bolts, whatever you want to buy, you tell the supplier that this is what I want, and the supplier will give you the price and the delivery date and delivery conditions. And there's a fixed price for that.

There are a few variations of the fixed-price contract.

1a. Fixed Price Plus Incentive Fee

In the Fixed Price Incentive Fee type of contract, you pay a fixed price, but then on top of that, there is an incentive as well.

Coming back to my example of basement development, the contractor tells me that this is what he will be doing, and I will be paying him $20,000. But then we agree that if contractors can make it faster, let's say two weeks early, then I will pay him $2,000 extra for that. That is a fixed price plus an incentive fee.

1b. Fixed Price Economic Price Adjustment

The next variation of the fixed price contracts is fixed price economic price adjustment.

Let's assume that a contract is for five or six years instead of making the basement. Let's say I'm building a refinery or building a big power plant or something that will take five or six years to make it. In that case, I might want to add some economic price adjustments, such as inflation. The contract price will increase depending on the inflation.

The contract will have a fixed price. But if there is a change in inflation, you will pay something extra to compensate for the inflation.

Sometimes the adjustment is related to commodities price such as copper. The contract will have a fixed price, but if the copper price goes 1% up, this is a certain additional price on top of the fixed price with an economic price adjustment.

2. Cost Reimbursable Contract

The second type of contract is the cost-reimbursable contract. In cost reimbursable, we will agree that this is the contractor's work scope, and we will reimburse the cost incurred by the contractor. This could be the cost related to material, workforce and everything. This is particularly more applicable when the scope of work is not clear.

In the cost-reimbursable type of contract, there are multiple variations.

2a. Cost Plus Percent Fee

The first one is Cost Plus Percent Fee. I will pay my contractor the cost, whatever cost this contractor is incurring, plus a certain percent fee on top of that.

In building the basement, I'm not sure what do I want? So, in that case, I might agree on the cost-reimbursable that whatever cost this contractor is incurring, I will pay something extra 10% extra on top of that. The contractor buys, let's say, flooring and, let's say, pays $5,000 for the flooring. I will pay $5,000 plus 10% on top of that plus labour charge and so on. This is cost reimbursable.

2b. Cost Plus Fixed Fee

The other variation of the cost reimbursable contract could be Cost Plus Fixed Fee. Let's say we agree that I will pay $2,000 as the fixed fee, and whatever cost is incurred by the contractor, I will pay that.

2b. Cost Plus Incentive Fee

The third variation of a cost-reimbursable contract is Cost Plus Incentive Fee.

In this case, I will agree on some incentives related to getting the better material or getting the project done faster or whatever the criteria are.

3. Time and Material contract

The third type of contract here is the time, and the material contract, also called T &M. The time (T) means whatever labour it takes, you pay based on the labour time, and the material (M) cost.

In this case, you pay the contractor for the time and material. But then you will say this is similar to the cost-reimbursable.

The difference between the cost-reimbursable and time and material contract is that in T&M, we fix the rate of labour and material expenditure beforehand. These are pre-agreed. When the contractor does this work of developing my basement, we would have already agreed that for every piece of roof light, let's say I will pay $120. For the flooring, I will pay this much amount per square foot.

Even the time rates are fixed. Whatever labour contractor is putting, we will agree that for every 1 hour of an electrician, let's say I'll pay $80.

So the labour rates and material rates are already fixed here in time and material contract.

So that is the difference between the cost reimbursement and time and material. In time and material, the costs are predetermined and agreed. In cost reimbursable, it is the actual cost that this contractor is incurring. I will have to pay for that cost plus, on top of that, either the percent fee or the fixed fee or whatever agreement we have.

So these are the common types of contracts which you can have.

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