PMP® Study: 3 Types of Contracts in Project Management

What Are Contracts in Project Management?

A contract in project management is a legal document between two parties, usually a buyer and a seller, that clearly states the scope, deadlines, payment terms, and each party's responsibilities. This is the very principle that ensures continuous understanding among participants from the beginning.

Usually, in projects, contracts are used when a project manager decides to hire an external vendor, subcontractor, or service provider to perform part of the work. It is the contract that ensures both parties are fully aware of what is expected, what will be delivered, by when, and for how much.

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Why Are Contracts Important in Project Management?

The choice of an inappropriate contract or the omission of important points in one can quietly disrupt even a well-thought-out project plan.

Here are a few reasons why contracts are important in project management:

1. They point out the scope precisely. With an efficient contract, the single source of misunderstanding is deliverables, so there can't be any "I thought you meant..." type of discussion during the project.
2. They distribute risk. The different contracts involved change ownership or delivery risk between buyer and seller in different ways. By doing this, you can select the right one.
3. They determine payment expectations. Explicit payment clauses not only avoid conflicts but also allow steady cash flow on both sides.
4. They handle the unexpected. With change management and termination clauses, you aren't up against the wall when the scope changes or things don't turn out as planned.
5. They safeguard intellectual property. Any work or data produced during the project is subject to a contract, leaving no room for ambiguity.

Did you know? Poor contracting practices erode almost 9% of annual revenue, rising to 15% or more in complex industries. (Source:World Commerce & Contracting, 'as of Aug 2025')

Types of Contracts in Project Management

In this article, we’ll define the three basic contract types and provide examples to help you understand when you’d use each of them.

1. Fixed Price Contract (FP)
2. Time and Material Contract (T&M)
3. Cost Reimbursable Contract (CR)

1. Fixed Price Contract (FP)

A fixed-price contract, also known as a lump-sum contract, is one in which a single fixed price covers the entire scope of work before the project begins. The vendor agrees to provide all services specified in the scope for that fixed sum, regardless of the actual expenses incurred in accomplishing the work.

This type of contracting is quite effective when the scope of the project is well-defined and not expected to change. The buyer is in a position of minimum financial risk since the prices are fixed. The biggest disadvantage is that the seller bears all the risk; any excess costs must be covered by them.

Below are a few types of fixed-price contracts:

• Fixed Price Incentive Fee (FPIF): Although the price is fixed, the seller is offered a performance-based incentive. The incentive can depend on one or more project metrics, such as performance, cost, or time.
• Fixed Price Award Fee (FPAF): If the seller's performance exceeds expectations, an additional amount (e.g., 10% of the total price) will be paid to the seller.
• Fixed Price Economic Price Adjustment (FPEPA): This contract sets a fixed base price but allows limited price adjustments when specific economic factors change, such as material costs, labor rates, or inflation. It is often used in long-term agreements where market prices may shift over time, helping balance cost predictability for the buyer with risk protection for the seller.

2. Time and Material Contract (T&M)

A time and materials contract (T&M contract), also known as a unit price contract, is a contract under which the buyer pays the seller for the actual time and materials used. Think of it as an hourly-rate agreement: the buyer will pay for each hour worked, plus any materials used during the project.

A T&M contract is ideal for freelancers or independent workers, short-term contracts, and projects where the requirements are unknown or not well-defined at the start of the contract.

It allows adjustments throughout the project and is therefore beneficial to both the client and the contractor. The drawback is that there's no fixed cost ceiling unless a limit is set, making it more difficult for buyers to predict total spend.

Common types include:

• Pure T&M (Time and Materials): Standard hourly/daily billing with no spending cap; seller is paid for all time and materials used.
• T&M Not-to-Exceed (NTE) / Capped T&M: Similar to pure T&M, except that the buyer sets a maximum amount or cost.
• Capital/Labor T&M: Separates labor costs from capital or material costs, billing each at a different agreed-upon rate.

3. Cost Reimbursable Contract (CR)

The cost-reimbursable contract, also known as a cost-disbursable contract, involves the buyer reimbursing the seller for allowable project costs incurred, plus a separate fee for the seller's profit. The total cost is not known in advance; it is revealed only after the project is completed.

This type is used when the project scope is unclear, or too many unknowns characterize the work to price accurately in advance. It enables sellers to continue without the fear of financial loss. The drawback is that costs may escalate without a defined limit, creating challenges for the buyer in managing the budget.

Below are a few types of cost-reimbursable contracts:

• Cost Plus Fee (CPF) or Cost Plus Percentage of Costs (CPPC)

The seller will get the total cost they incurred during the project plus a percentage of the fee over cost; this is always beneficial for the seller.

• Cost Plus Fixed Fee (CPFF)

The seller is paid a fixed amount that is agreed upon before work commences. The costs incurred for the project are reimbursed in addition to this, regardless of project performance.

• Cost Plus Incentive Fee (CPIF)

A performance-based incentive fee will be paid to the seller in addition to the actual costs they have incurred on the projects. With this type of contract, the incentive motivates the seller to meet or exceed the project’s performance metrics.

• Cost Plus Award Fee (CPAF)

The seller will receive a bonus (the award fee) plus the actual costs incurred on the projects; this type of contract is very similar to a CPIF contract.

How to Choose the Right Contract Type?

Understanding the types of project management contracts is only half of the job; knowing when to use each is equally important. Here are the things to remember:

• Scope clarity: If the scope is well defined and unlikely to change, go for a fixed-price contract. If it's in doubt or subject to change, a cost-reimbursable contract provides you with the flexibility to adapt.
• Risk tolerance: Fixed-price places the financial risk on the seller. Cost-reimbursable puts it on the buyer. Know where your project is before making a decision.
• Nature of work: Short-term, freelance, or continuous with no fixed point for time and materials.
• Budget predictability: If the buyer needs the firm's number upfront, a fixed price is the safest bet. If cost predictability is less of an issue, CR or T&M can work.

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Why Project Managers Should Understand Contract Types?

A project manager who lacks knowledge of contract types is, in effect, handing over the financial and operational fate of their project to someone else. 

Every contract decision has a direct impact on scope, budget, risk allocation, and vendor accountability. Knowing which contract suits which situation means fewer disputes, tighter cost control, and projects that actually end as planned.

Did you know? 83% of executives say their contracts are too rigid to adapt to change, locking them into outdated terms and preventing innovation when markets shift. (Source: World Commerce & Contracting, 'as of Aug 2025’)

Risks and Advantages of Each Contract Type

The types of project contracts in project management each come with real trade-offs, and no single one is the right fit for every situation. Here's a breakdown:

Also Read: Risk Management Strategies in Project Management

Examples of Contract Types in Project Management

Sometimes the easiest way to understand what contract fits best is to see it in a real context.

Fixed-Price Contract

• A project manager agrees with a design agency on a flat fee of $10,000, scope, deliverables, and timeline all locked in before work starts.
• Similarly, a PM responsible for an office construction project signs a fixed-price $500,000 contract with a contractor.

In both cases, the project manager knows precisely what's being spent before a single task kicks off.

Time and Materials Contract

• A project manager hires a freelance developer to work on the project partway through to build new features, as the project scope is continually changing. A flat rate makes more sense than a fixed price.
• The same logic applies if a PM is hiring an outside consultant for ongoing support; billing by the hour keeps things flexible as project needs change.

Cost-Reimbursable Contract

• A project manager working on a government defense project can't specify the full scope at the outset, so all contractor costs are reimbursed as work progresses.
• In R&D projects, such as pharmaceutical research, PMs regularly use this type of contract because the unknowns are too significant to price at the beginning of the project.

Key Takeaways

• The three types of contracts in project management, Fixed-Price, Time & Materials, and Cost-Reimbursable, each share the risk differently between the buyer and the seller
• Choosing the wrong type of contract can quietly lead to scope disputes, budget overruns, and strained vendor relationships before the project even hits the midpoint
• Fixed price is good for well-defined scopes, T&M is best for evolving or short-term work, and cost reimbursable is best for high-risk projects where the entire scope can't be determined up front

FAQs

1. What are the 7 different types of contracts in project management?

The seven main contract types in project management fall under three categories: fixed-price, cost-reimbursable, and time and materials. These include Firm Fixed Price (FFP), Fixed Price Incentive Fee (FPIF), Fixed Price with Economic Price Adjustment (FP-EPA), Cost Plus Fixed Fee (CPFF), Cost Plus Incentive Fee (CPIF), Cost Plus Award Fee (CPAF), and Time and Materials (T&M). Each type differs in how it shares cost and performance risk between the buyer and seller.

2. What is the difference between fixed-price and time and materials contracts?

A fixed-price contract sets a single agreed-upon cost for the entire project. This makes it a strong choice when the scope, timeline, and deliverables are clearly defined. A time-and-materials contract, on the other hand, pays the seller based on the actual time spent and materials used. This offers more flexibility when project requirements are likely to change.

3. What is the difference between fixed-price and cost-reimbursable contracts?

A fixed-price contract provides the buyer with greater cost certainty because the seller commits to completing the work for a set price. A cost-reimbursable contract works differently, since the buyer pays the seller for actual allowable costs, plus an additional fee. This type is usually better suited for projects with uncertain scope or higher risk.

4. What elements should a legally binding project contract include?

A legally binding project contract should clearly define the project scope, deliverables, payment terms, timeline, roles and responsibilities, change-control process, dispute-resolution terms, termination clauses, confidentiality terms, and signatures from both parties. These elements help reduce confusion and protect everyone involved in the agreement.