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5 Major Types of Construction Contracts

  • Writer: Cost Construction Accounting
    Cost Construction Accounting
  • Jul 12, 2023
  • 7 min read

Updated: Nov 12

Construction contracts are the backbone of every project you take on. Whether you're a general contractor bidding on a commercial build or a subcontractor negotiating terms, the type of contract you sign directly impacts your cash flow, profitability, and risk exposure.

Yet too many construction businesses sign contracts without fully understanding the financial implications. The wrong contract type can drain your profits, create cash flow nightmares, or leave you exposed to unexpected costs. The right one can protect your margins and set your project up for success.

In this guide, we'll break down the five major types of construction contracts, explain their accounting considerations, and help you understand which situations call for each contract type.

types of construction contracts

Why Contract Type Matters More Than You Think

Before we dive into the specifics, let's be clear: your contract type determines how you recognize revenue, manage job costs, and calculate profit. It affects everything from your tax obligations to your ability to secure financing.

Many contractors focus solely on winning the bid, but smart contractors know that the contract structure is just as important as the project scope. Understanding these differences isn't just good business practice, it's essential for survival in today's competitive construction market.

1. Lump Sum Contracts (Fixed-Price Contracts)

Lump sum contracts are exactly what they sound like: you agree to complete a defined scope of work for one fixed price. This is one of the most popular contract types in construction because it provides cost certainty for owners and profit potential for contractors who estimate accurately.

When to Use Lump Sum Contracts:

  • The project scope is clearly defined with minimal expected changes

  • You have confidence in your cost estimating abilities

  • The owner wants budget certainty upfront

Key Accounting Considerations:

Revenue Recognition: You'll typically use the percentage-of-completion method, recognizing revenue as work progresses. This requires accurate job costing and regular progress tracking. Without proper systems in place, you risk recognizing revenue too early or too late, which can distort your financial picture.

Change Order Management: While the base price is fixed, scope changes require documented change orders. Every change order impacts your revenue, costs, and timeline. Failing to track these meticulously can lead to disputes and profit erosion.

Labor Burden Accuracy: Labor costs often represent 40-50% of your project budget. You must calculate the full labor burden including wages, payroll taxes, workers' compensation, health insurance, and benefits before setting your price. Underestimating labor burden is one of the fastest ways to turn a winning bid into a losing project.

Contingency Planning: Smart contractors build contingency reserves into their estimates to cover unforeseen costs. Material price fluctuations, weather delays, and labor shortages can eat into your margins quickly. Your accounting system should track actual costs against budgeted amounts in real-time so you can adjust before it's too late.

2. Cost-Plus Contracts

In cost-plus contracts, you're reimbursed for actual project costs plus an additional fee (either a fixed amount or percentage) for profit. This contract type shifts financial risk from the contractor to the owner.

When to Use Cost-Plus Contracts:

  • The project scope is unclear or likely to change significantly

  • Emergency or fast-track projects where time matters more than cost certainty

  • The owner wants transparency in project costs

Key Accounting Considerations:

Detailed Job Costing: Every dollar spent must be tracked and categorized properly. You need systems that capture direct labor, materials, equipment, subcontractor costs, and allocable overhead. Your client has the right to audit your costs, so documentation must be impeccable.

Profit Fee Application: Whether you're earning a percentage of costs or a fixed fee, your accounting system must apply the markup correctly and consistently. Make sure you understand what costs are reimbursable and what percentage or fee applies to each category.

Time and Material Documentation: Maintain detailed daily reports, material receipts, equipment logs, and timesheets. Incomplete documentation leads to reimbursement disputes and can damage client relationships.

Cost Control Discipline: Just because the owner pays actual costs doesn't mean you should ignore cost control. Inefficient work practices and poor project management can damage your reputation and make future work harder to secure. Implement procedures to track, report, and manage costs proactively.

3. Time and Material Contracts

Time and materials (T&M) contracts pay contractors based on actual labor hours and material costs incurred, often including a markup to cover overhead and profit. These contracts usually feature a "not to exceed" clause to cap total project costs, providing some cost control.

When to Use T&M Contracts:

  • Small repair or maintenance projects

  • Projects with undefined scope or high uncertainty

  • Emergency work where time is critical

Key Accounting Considerations:

Precise Time Tracking: Since labor is your primary revenue source, you need bulletproof time tracking. Every hour must be recorded accurately with supporting documentation. Mobile time-tracking apps can help field workers log hours in real-time.

Materials Management: Track every material purchase with receipts showing actual costs. Apply your agreed-upon markup consistently. Poor materials tracking leads to disputes and leaves money on the table.

Markup Structure: Your hourly rates and material markups must cover not just direct costs but also your overhead and desired profit. Many contractors underprice T&M work because they forget to factor in their full cost structure.

Client Communication: The biggest challenge with T&M contracts is cost unpredictability for owners. Provide regular cost updates and projections to avoid sticker shock. Transparent communication builds trust and leads to repeat business.

4. Unit Price Contracts

Unit price contracts work well for projects where work can be measured in specific units cubic yards of excavation, square feet of concrete, linear feet of pipe, etc. You establish a price per unit, and final payment is based on actual quantities installed.

When to Use Unit Price Contracts:

  • Projects where quantities are difficult to determine precisely upfront

  • Civil and infrastructure projects (roads, utilities, earthwork)

  • Projects with repetitive work that's easy to measure

Key Accounting Considerations:

Accurate Unit Cost Development: Your unit prices must reflect all costs associated with that unit of work direct labor, materials, equipment, and allocated overhead. Underestimate any component and you'll lose money on every unit completed.

Quantity Verification Systems: Implement systems to measure and verify quantities as work progresses. Disputes over quantities completed are common with unit price contracts. Photos, daily reports, and third-party verification can protect you.

Overhead Allocation: Don't forget to build mobilization, demobilization, project management, and general conditions into your unit prices. These costs are real even though they're not tied to specific units of work.

Change Management: Quantities may vary from initial estimates, but scope changes still require formal change orders. Document any work that falls outside the original unit price schedule and negotiate pricing promptly.

5. Design-Build Contracts

Design-build contracts make you responsible for both design and construction under a single contract. This integrated approach can streamline project delivery but requires additional capabilities and management expertise.

When to Use Design-Build Contracts:

  • Fast-track projects where overlapping design and construction saves time

  • Projects where innovation and value engineering are priorities

  • Owners who want single-point accountability

Key Accounting Considerations:

Integrated Cost Tracking: You must track costs across both design and construction phases. Your accounting system needs to handle architect and engineer fees, design revisions, permitting costs, and construction costs in one integrated structure.

Design Phase Revenue Recognition: Determine how you'll recognize revenue during the design phase. Some contractors recognize design revenue separately, while others blend it with construction revenue over the project lifecycle.

Change Control Processes: Design changes impact construction costs, and construction challenges may require design modifications. Your accounting system must track the cascading cost impacts of changes across both phases.

Risk and Profitability Management: Design-build contracts offer higher profit potential but also greater risk. You're responsible if the design has errors, if the design can't be built within budget, or if design delays impact construction. Factor these risks into your pricing and maintain appropriate contingency reserves.

Making the Right Contract Choice for Your Business

Choosing the right contract type isn't just about what the owner wants, it's about understanding your own capabilities, risk tolerance, and financial systems.

Ask yourself these questions before signing your next contract:

  • Do we have the estimating accuracy for a lump sum contract?

  • Can our accounting system handle the documentation requirements of cost-plus work?

  • Do we have the project management capabilities for design-build?

  • Are our overhead rates and markup structures appropriate for the contract type?

The Role of Solid Accounting in Contract Success

Here's the reality: the best contract in the world won't protect you if your accounting systems can't track costs accurately, recognize revenue appropriately, and provide real-time financial visibility.

Every contract type we've discussed requires:

  • Accurate job costing systems

  • Real-time cost tracking and reporting

  • Proper revenue recognition methods

  • Strong internal controls and documentation

  • Regular financial analysis and forecasting

Without these fundamentals in place, you're flying blind regardless of contract type.

Partner with Experts Who Understand Construction

At Construction Cost Accounting, we specialize in helping contractors, subcontractors, and construction business owners implement financial systems that support profitable project delivery. We understand that construction accounting isn't just about recording transactions, it's about providing the financial intelligence you need to make smart decisions about contracts, pricing, and project management.

Whether you're managing lump sum contracts, navigating the complexities of cost-plus work, or scaling your business with design-build projects, we ensure you have accurate, timely financial data to protect your margins and grow your business.

Time to Take Action

The contracts you sign today determine your profitability tomorrow. Are you choosing the right contract types for your projects? Do your accounting systems give you the visibility you need to manage contract performance?

If you're uncertain, it's time to reassess your approach. Strong financial systems and expert accounting guidance aren't luxuries, they're necessities in today's competitive construction market.

Let CCA be your partner in building a more profitable construction business. Reach out today to learn how our specialized bookkeeping services can help you master contract accounting and focus on what you do best: building exceptional projects.

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