If you're running a construction company, how you price a job can have a big impact on both your profit and the amount of risk you're taking on.

There are quite a few ways construction contracts can be structured, but four of the more common pricing methods are fixed price, cost plus, time and materials, and unit price.

Each of these methods has its advantages and disadvantages. It depends on the type of work you're doing, how predictable the project is, and how much risk you or the customer are comfortable taking on.

The Four Common Pricing Methods

Fixed Price / Lump Sum

With a fixed-price contract, you agree to complete a defined scope of work for a set amount.

For example, you may agree to build an addition for $350,000. If your actual costs come in lower than expected, your profit may be better. If labor, materials or subcontractor costs come in higher than expected, those additional costs generally come out of your margin unless the contract allows for an adjustment.

The nice part is that the customer knows the price up front, and the contractor can earn a nice profit if the estimate is accurate and the job is managed well.

The downside is that you, the business owner, are taking on the risk. Missing something in the bid, underestimating labor or dealing with unexpected cost increases can turn what looked like a profitable project into a loss.

Cost Plus

Under a cost-plus contract, the customer generally pays the actual costs of the project plus an agreed contractor fee or markup.

This can work well when the exact scope or final cost of the project isn't completely known at the beginning. Rather than trying to guess every possible cost and building that risk into a fixed price, the contractor is reimbursed for the actual costs and then earns an agreed fee on top.

For the contractor, this reduces some of the risk of material or labor costs being higher than expected.

On the other hand, the customer has less certainty about the final price. Your job costing and bookkeeping need to be accurate and current, so you can bill the customer appropriately and avoid confusion.

Time & Materials

Time and materials is similar to cost plus, but the customer is generally billed based on the labor hours worked plus the materials used on the job.

This can make a lot of sense for service work, repairs, troubleshooting, remodels or other projects where it is difficult to know exactly how long the job will take before you begin.

For the contractor, it can reduce the risk of quoting a ten-hour job that ends up taking thirty hours.

The downside is that the customer doesn't know the final cost at the beginning, and they may be more sensitive to the number of hours being billed. Because of that, some time-and-material contracts include a maximum or "not to exceed" amount.

Unit Price

With unit pricing, the customer pays an agreed amount for each unit of work actually completed.

This can be based on square feet, linear feet, cubic yards, individual fixtures or another measurable unit.

For example, a specialty contractor may charge $12 per square foot and complete 5,000 square feet of work. The final contract amount would then be based on the actual quantity completed.

That would generally be different from a contractor who uses $12 per square foot simply to calculate an estimate and then signs a fixed contract for $60,000. In that case, the square footage was used to build the estimate, but the customer is still paying a fixed price.

Unit pricing can work nicely when the work is repetitive and easy to measure. The contractor also doesn't have to know the exact final quantity at the beginning.

The important part is making sure your price per unit is profitable and includes all aspects of your costs, including overhead.

Contract Modifiers

The contract may also include additional terms that change how much risk the contractor or customer is taking. Here are a few examples of contract modifiers.

One common example is a Guaranteed Maximum Price. You may have a cost-plus contract, but the customer agrees that the total price will not exceed a certain amount unless there are approved changes to the project.

There may also be shared-savings arrangements where the contractor receives part of the savings if the project comes in below a target amount.

On longer projects, you may also see clauses dealing with significant increases in material or labor prices. Other contracts may include bonuses for early completion or financial consequences if certain deadlines aren't met.

These terms can have a big impact on the profitability of the project, so it's worth understanding them before you agree to the contract rather than after the job is already underway.

Change Orders

Regardless of how the original project is priced, construction projects change (as I'm sure you've dealt with many times).

The customer may upgrade materials, add additional work, change the plans or request something that wasn't included in the original scope, which results in a change order.

A good change order should clearly document what is changing, how the contract price is changing and whether the project schedule is changing as a result.

It's also important that approved change orders make their way into your accounting and job-costing records. If you started with a $500,000 contract and approved $75,000 of additional work, your team should be reviewing that job based on a $575,000 contract rather than continuing to compare the project against the original amount.

Which method is right?

The goal is a pricing system that produces profitable jobs for your company. Understanding these different pricing methods can help you review the pros and cons, and choose the one that works best for your particular business.

And, whatever pricing method you're using, good job costing is what helps you figure out whether the way you're pricing the work is working.