In the business world, contracts are used to make business deals and establish partnerships. The parties involved in the business involvement decide the type of contract.
Usually, the type of contract used for business interactions varies depending on the type of work and the nature of the industry.
A contract is simply a detailed agreement between two or more parties. One or more parties may provide products or services in lieu of anything provided by other parties (the customer).
The contract type is the key relationship between the parties involved in the business, and the contract type determines the risk of the project.
Let's take a look at the most widely used types of contracts.
Fixed price (lump sum)
This is the simplest type of all contracts. The conditions are quite simple and straightforward.
Simply put, the service provider agrees to provide a certain service for a certain period of time, and the customer agrees to pay a fixed amount of money for the service.
This type of contract can define different stages of delivery, as well as KPIs (key performance indicators). In addition, the contractor may have acceptance criteria defined for the main stages and final delivery.
The main advantages of this type of contract are that the contractor knows the total cost of the project before it begins.
Unit price
In this model, the project is divided into units and a fee for each unit is determined. This type of contract can be introduced as one of the more flexible methods compared to a fixed-price contract.
Usually, the owner (contractor/client) of the project decides on the estimate and asks bidders to offer a price for each element of the project.
After bidding, depending on the amount of bids and the qualifications of bidders, the entire project may be transferred to the same service provider, or different units may be allocated to different service providers.
This is a good approach where different design units require different knowledge to complete.
Cost plus
In this contract model, the service provider is reimbursed for its equipment, labor, and other expenses, in addition to the contractor paying an agreed fee to the service provider.
In this method, the service provider must offer a detailed schedule and resource allocation for the project. In addition, all costs should be properly listed and should be communicated periodically to the contractor.
Payments can be paid by the contractor at a certain frequency (for example, monthly, quarterly) or by the end of the stages.
stimulus
Incentive contracts are usually used when there is some degree of uncertainty in the cost of the project. While there are near-accurate estimates, technological challenges can affect shared resources as well as efforts.
This type of contract is common to projects that include pilot programs or projects that use new technologies.
There are three cost factors in an incentive contract; target price, target profit and maximum cost.
The main mechanism of the incentive agreement is the division of any excess of the target price between the client and the service provider in order to minimize business risks for both parties.
Retainer (Time & Material – T&M)
This is one of the most beautiful tasks in which two or more parties can participate. This type of interaction is the most risk-free type, where the time and material used for the project are set at a price.
The contractor only requires to know the time and material for the project in order to make payments. This type of contract has short delivery cycles, and for each cycle, separate evaluations are sent by the contractor.
Once the contractor signs the estimate and terms of reference (SOW), the service provider can begin work.
Unlike most other types of contracts, retainer contracts are primarily used for long-term business operations.
Percentage of construction fee
This type of contract is used for engineering projects. Based on the necessary resources and materials, the cost of construction is estimated.
The client then enters into a contract with the service provider and pays a percentage of the project cost as a fee for the service provider.
As an example, let's take the scenario of building a house. Suppose the estimate is $230,000.
When this project is concluded with a service provider, the client may agree to pay 30% of the total cost as a construction fee, which is $69,000.
Conclusion
Choosing the type of contract is the most important stage of concluding a business agreement with the other party. This step identifies the possible risks of the interaction.
Therefore, companies should enter into contracts where there is minimal risk to their business. It's always a good idea to participate in fixed rates (fixed-price) when the project is short-term and predictable.
If the nature of the project is of a research nature, it is always better to choose a fixative or cost plus the types of contracts.
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