13 Types of Contracts for Beginners: How To Choose the Right One

As per Cottrill Research, about 80% of business deals are regulated by contracts. Contracts provide clarity about the responsibilities of each party and prevent legal issues down the road.

But you can’t sign the same contract in different situations. You can't go for a Cost Plus contract if you're tight on budget. Instead, you would have to sign a fixed-price contract.

So you should understand the different types of contracts if you want to make the most of them.

That’s why we put together this guide to explain the types of contracts and help you figure out the best one for your needs. Let’s get into it!

What is a Contract?

A contract is a legal agreement, written or spoken, between two or more parties that obliges all in the contract to perform certain tasks (e.g., payment for property or services) or to refrain from specific actions (e.g., disclosure of information).

For example, when you take a loan, you sign a paper with the lender that specifies the loan, terms of repayment, interest, and penalties. That’s called a contract.

Essentially, a contract is a written promise that is backed by the court system. In case one party breaks the agreement, the other party has the legal power to enforce the terms of the contract.

So a contract makes sure everyone keeps their word and follows the rules of the deal.

Elements of a Contract

All legally binding contracts must contain these six elements to be enforceable by the law:

• Offer: One party must offer to carry out or refrain from certain activities.
• Consideration: There should be an exchange or bargain for something valuable.
• Acceptance: A clear expression by the involved parties shows their agreement to the original terms and conditions.
• Awareness: Each party must be aware that they are entering a legally binding contract.
• Capacity: Each party must have the legal capacity to understand what they are signing, without being underage, under the influence of drugs, or having any mental disorders.
• Legality: The contract should not violate the laws or the public policies of the country in which it is made.

Types of Contracts

Here are 13 main types of contracts used in day-to-day business dealings.

1. Fixed price contracts

A fixed-price contract, sometimes called a lump-sum contract, is an agreement in which the cost of products or services is fixed in advance.

A lump-sum contract is defined by the following features:

• The seller sets the predetermined total cost for services.
• The final cost cannot change until the end of the contract.
• The burden of any additional expense is borne by the seller.
• The drafting and approval procedure of this contract usually takes a longer time.

Fixed price contracts may include additional bonuses for early completion of the tasks or penalties for missing the deadlines.

They also ensure financial security for the buyer and a good profit for the sellers if they price properly and complete tasks within the schedule.

These contracts should be used when the time and resources required to complete a project can be determined accurately.

2. Cost reimbursement contracts

A cost reimbursement contract, also known as a cost-plus contract, is the opposite of a fixed-price contract.

Here a buyer reimburses the seller for all the legitimate actual costs incurred for completed work, with an additional sum for profit.

In addition to this, if there are any additional costs other than material and labor, then the buyer is responsible for paying that as well. So you have to use accounting software to keep a check on all these costs.

The seller gives an estimate of the total cost to the buyer at the start. There is a ceiling price that the seller cannot exceed without the approval of the buyer.

Cost plus contract allows the seller to start a project right away with a draft and make changes in the structure later. This contract is used when the overall scope of work is expected to vary considerably during the execution of the contract.

Cost plus contract is risky for the buyer because the final costs cannot be pre-estimated, and they have to pay for all incurred costs.

3. Unilateral contracts

Under a unilateral contract, one party (the offeror) promises to pay another party after they complete a specific task or they face a certain event.

A unilateral contract can be accepted only if the task mentioned by the offeror is accomplished or the conditions in the agreement are met.

For example, insurance companies offer to pay their client only if they face an event mentioned in the contract.

Another example could be a promise of reward for lost items, i.e. $100 for anyone who finds my lost bag. The offeror would pay $100 only if the person finds their bag and returns it.

Once the terms of the offeror party are met, they become obliged by the law to pay what they promised.

4. Bilateral contracts

When it comes to business transactions, bilateral contracts are the go-to for ensuring a legally binding mutual agreement between two parties.

These contracts involve an exchange of something of value, such as money or goods, and require one party to make an offer that must be accepted by the other.

In fact, bilateral contracts are so commonplace that you've likely participated in one without even realizing it.

Have you ever purchased an item at a mall in exchange for money? Congratulations, you've participated in a bilateral contract!

A bilateral contract is mostly used in sales and procurement dealings when one party offer to pay another party for their goods or services.

5. Time and materials contracts

A time and materials contract is an agreement where a buyer pays a contractor for the time they spend working on a project, plus the cost of any materials used.

It’s different from a cost-reimbursement contract, where the buyer has to pay for the cost of the materials plus a fixed fee for profit.

So time and materials contract is a better option if the project’s scope or duration is uncertain. It is also easy to set up and provides the buyer with flexibility as schedule changes.

However, the time taken and material used during the project must be tracked carefully to provide the buyer and the contractor with an accurate sum of the total cost. So, this demands proper project management.

This contract is frequently used for services in which the level of effort or the duration of the job cannot be calculated initially.

For example, the time required for the renovation of an old building cannot be determined initially. It can also be used when the requirements of work or material prices are likely to change.

6. Unit price contracts

A “unit” refers to a portion of work, material, or both. It can take any number of units to complete a project.

For example, the order of concrete by the load for building a road. Every load of concrete is a unit with a fixed price.

Under a unit price contract:

• The seller provides a specific price for each unit.
• The buyer pays the price for the total units spent on work at the completion.
• The number of units required for a project does not need to be predetermined.

A unit price contract is used when the work includes repetitive tasks, and the total amount of work or material required cannot be determined accurately.

Relate it to the concrete example; the total amount and price of concrete required cannot be determined initially. Breaking it down into units makes it much simpler for the buyer and the seller to keep a record of material and price.

7. Option contracts

An option contract is a financial contract between an option writer (seller) and an option buyer (option holder).

When you buy an option, you gain the right, but not the obligation, to buy or sell an asset at a fixed price at or before an upcoming date.

An option contract includes the following key terms:

• Underlying asset: The asset that the option contract is based on, such as a stock or a commodity.
• Option exercise: The act of using the option, which results in the delivery of underlying assets.
• Strike price: The preset option's price for the underlying asset.
• Expiry date: The date by which the option must be exercised, or it will expire.
• Premium: The upfront price the option buyers pay for purchasing an option.

There are two types of options; a call option gives the owner the right to purchase something at a fixed price.

For instance, if you hold a call option to buy 100 shares of a company's stock at $50 per share, and the stock price rises to $60 per share, you can exercise your option and buy the shares at the lower strike price, earning a profit of $10 per share.

Similarly, a put option gives their owners the right to sell something at a certain price in the future.

This contract is commonly used when you’re dealing in stocks and shares to purchase or sell something in the future at a fixed price.

8. Output contracts

A contract under which a manufacturer or the seller agrees to sell the entire production (output) of a specific product to one buyer. In return, the buyer purchases all the output produced by the seller, irrespective of the quantity the buyer needs.

Output contract allows manufacturers to focus on production quality instead of worrying about sales and distribution.

This is because their production already has a market and a specific selling price. The buyers entering an output contract gain exclusive access to quality products at a reasonable price.

However, an output contract may prevent the seller from selling their products to other potential buyers.

The buyers are also at risk. If the demand for a product declines unexpectedly, the buyer will have to sell the product at a loss and face the issue of inventory management.

This contract should be used only when the buyer wants to be the only seller of an exclusive, highly-demanded product in the market.

9. Requirements contracts

A requirement contract is the opposite of an output contract. Here buyers agree to buy only the amount of product they need.

In return, the buyer guarantees that the seller will be the only supplier of that particular product.

In this scenario, the sellers are free to sell their productions to other consumers as long as they meet the demands of the buyer.

A major problem with both forms of the above-mentioned contracts is that they allow one party to disregard its responsibilities to the other.

In an output contract, a seller may slow or cease production by declaring they have produced all they could. Similarly, in a requirements contract, the client may refuse to purchase anything from the seller, saying that they no longer require the product.

Therefore, a level of trust must be developed between the parties before entering the contract.

10. Express contracts

A contract where the terms and conditions are stated verbally or in written form when the contract is made. These contracts can be made via emails, text messages, calls, and written statements. An express contract must include:

• Clearly defined terms and conditions to avoid confusion between parties.
• All the six elements of a legally binding contract (as mentioned above).
• Parties must express their agreement in written or verbal form.

This type of contract can be easily implemented as there is no room for ambiguity, and the obligations of both parties are clearly defined.

11. Implied contracts

An implied contract is opposite to an express contract. This contract automatically comes into existence because of the way a party acts.

They don’t need to be written down or spoken out loud. For example, if you take your car for a wash, it is implied that you will pay for it. You don’t have to formulate a written agreement to pay the service provider for a car wash.

Implied contracts have two main types:

• Implied-in-fact: Exists when parties take certain actions.
• Implied-in-law: This exists when the law specifies the obligations of parties to one another.

Implied contracts are seldom used in business dealings. Mostly, companies prefer to write down the terms of a contract as it makes discussions easier.

12. Adhesion contracts

An adhesion contract, also called a standard form contract, is a one-sided agreement where the party with greater bargaining power decides the terms and conditions of a contract.

The other party has no bargaining power. They can either accept all the conditions of the contract or decline them.

Businesses with a large number of clients are usually the ones using an adhesion contract for their customers. All of these clients are subject to a common set of terms and conditions.

An adhesion contract is frequently used in insurance companies, leases (rental contracts), loans, and automobile purchases.

For example, people buying access to recreational activities like boating have to sign liability waivers before participating in the activity.

To be enforceable, adhesion contracts must be offered as “take it or leave it” contracts.

Adhesion contracts are becoming increasingly popular as a result of increased digital purchasing.

They increase efficiency and reduce transaction costs by eliminating the need for customized contracts. They are useful while dealing with a large number of customers.

13. Aleatory contracts

A legally binding agreement in which a certain action is triggered by an incident is called an aleatory contract.

For example, insurance companies pay their customers only after they face a certain situation, i.e. a car accident.

This trigger event cannot be predicted by either party. They can only promise to perform certain actions if the event occurs in the future.

How to Choose the Right Contract Type?

Understanding the contract types isn’t enough to choose the right one. Several factors are also involved in determining a suitable contract type for a particular situation.

Here are some factors you can consider while choosing the right contract type for yourself:

1. Price and cost evaluation

You should perform calculations to see how much profit you are getting from a particular transaction. Is this the maximum profit you can get? Are there any better options that offer more profit for less investment?

2. Complexity and type of requirements

Contracts associated with the government usually have complex requirements with high-risk assumptions. You should use a combination of different contract types when the requirements are too complex.

3. Urgency of requirements

You can choose a contract type with greater risk if you want something immediately from a party. But avoid agreeing to unreasonably one-sided terms in a contract.

4. Contractor analysis

Make sure the other party is reliable and capable of finishing your project on time. Also, check out if they have the skill set required for the task you assign them and that they will not be the cause of any legal issues.

5. Project duration

Make sure you are aware of the time a project will take to complete. Contracts stretching over long periods may require analyzing the market and price adjustments.

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