Understanding the type of contract you are working under or to use on your project is one of the more important elements of Project Management. After all, the contract sets the scope and compensation and what could be more essential than that? However, different circumstances require different types of contracts. The different types of contracts allow more or less flexibility, and allocate different amounts of risk to the contractor and owner.
There is usually a cost associated with assuming risk, so contracts where the contractor bears most of the risk typically cost more. However, in some cases the contractor may be better able to mitigate the risk than the owner so having the contractor assume that risk may be more economical. It all depends on what the goals of both parties are. So here are some of the most common types of contracts and a brief definition of the contract type.
Fixed Price (FP or FFP - "firm fixed price") also called "Lump Sum"
The simplest type of contract. The owner specifies the work and the contractor gives a price. In this case the contractor assumes almost all of the risk and as a result reaps whatever profit there is. Fixed price contracts are often used in governmental contracting as they give an easy way to compare competitive bids and to budget for the work as all the uncertainty in actual price becomes the responsibility of the contractor. On the other hand, this may not be the cheapest way to get the work done. A side effect of the fixed price contract is the Change Order which modifies the initial contract for unforeseen conditions and changes. Some contractors are highly skilled at generating change orders which can boost profits on the job. In some cases change orders can equal the size of the original contract. Litigation is often more expensive than construction, so arbitration and settlement are typical in these cases.
Time and Materials (T&M)
Simple billing at pre-negotiated rates for labor and materials on a project. Some Fixed Price contracts specify this as a method for determining costs of change orders. Labor rates include a certain percentage markup for overhead. In this arrangement all risk goes to the owner.
Cost Plus Fixed Fee (CPFF or sometimes just Cost Plus)
Also fairly simple. This type of contract shifts most of the risk to the owner, but also allows the owner a high degree of flexibility. The contractor under this form of contract has profit at risk and will seek to minimize cost/duration to return a higher proportional profit margin. This type of contract is more common on projects which have high amounts of risk and uncertainty which would scare contractors into giving impossibly high bids, or where the owner just needs resources to work on a project.
The "fixed fee" is typically a percentage of estimated costs and the contractor is reimbursed for other allowable costs. The difference between CPFF and CPPC is that for fixed fee, the total amount of the fee is decided in advance based on estimates.
Cost Plus Percentage of Costs (CPPC)
This is very similar to the cost plus fixed fee contract except that the contractor bears even less risk. Their fee is calculated based on a percentage of actual costs. It is generally believed that having a fee at risk is a motivating factor for contractors, so this approach is not allowed for federal government contracts (though there may be loopholes...?) It is very similar to T&M. Good work if you can get it.
Cost Plus Incentive Fee (CPIF)
This type of contract uses an incentive fee for motivating better performance than you would get with percentage or fixed fee. In addition to a fee, an incentive is paid for beating a schedule or cost target. Like having the fee at risk, is intended to motivate the contractor to minimize costs and duration. Determining the appropriate incentive is one difficulty, another is that once the target has been missed, the incentive is no longer a motivating factor. Often the incentive fee is calculated as a percentage of savings and is shared by the owner and the contractor. The flip-side of incentive fees are liquidated damages.
While not really a contract type, Liquidated Damages are often part of Fixed Price contracts. They are the opposite of an incentive payment and are payments made by the contractor to the owner for failing to perform to a target date. The name liquidated damages comes from the practice of determining a pre-agreed monetary (thus liquidated) cost for damages to the owner's operations. For example, late completion of a new production facility may cost the owner additional costs to keep an aging and inefficient facility running, or the presence of the contractor may impair the owner's profitable use of a facility. Rather than determining these costs at the end of the contract, the costs are negotiated at the beginning and are usually quite large. This serves to motivate the contractor and gives the contractor the cost information needed to accurately determine the best course of action. It is intended to reduce the costs of litigation. Liquidated damages may apply to the contract as a whole or to smaller elements of it. For example, on a contract where a road is being resurfaced during nighttime hours, failing to have it back in operation by a certain time each day may be cause for liquidated damages.
Fixed Price Incentive Fee (FPIF)
Similar to Fixed Price but with an incentive fee. Motivation to perform is the reason.
So those are the most common contract types. Of course a contract can take any form that two parties can agree too (and which is not prohibited by law) so hybrids of these forms are possible. For the PMP Exam knowing the common types is probably the most important thing. Contract evolution beyond Time and Materials is all about how risk is allocated to the different parties and how to motivate one party or the other to act in a certain manner. For the most part you do get what you pay for... or conversely, you don't get what you don't pay for.