A typical question in the PMP exam would present a procurement scenario. The scenario would provide some details about the Contract the project manager is using. The question would then ask who has more Risk in the described scenario – the Buyer or the Seller. You will have to first understand which Type of Contract is being described in the situation and then answer the question.
The definition and explanation of types of Contracts is part of Procurement Management Knowledge Area of the PMBOK® Guide. PMBOK® Guide talks about three basic types of Contracts. The Three basic Types of Contracts are further divided into few sub-types. In this article am going to list all what you need to know about the contract types for the PMP/PMI-RMP exam.
Now, if an organization decides to buy/outsource from one or more companies, it must select the type of contract it needs. In selecting what type of contract to use, the primary objective is to have risk distributed between the buyer and seller so that both parties have motivation and incentives for meeting the contract goal. The following factors may influence the type of contract selected:
- Type and complexity of requirement.
- Extent of price competition.
- Cost and price analysis.
- Urgency of requirement or performance period.
- Frequency of expected changes.
- Industry standards of types of contracts used.
- Whether or not there is a well-defined statement of work.
- Overall degree of cost and schedule risk
Before I list the basic types of contracts, we need to agree on the contract definition, It is a legally binding agreement between two or more parties. Usually, one party is known as a buyer and the other the seller. The contract is the key to the buyer and seller relationship. It provides the framework for how they will deal with each other.
Basic Types of Contracts
- Fixed Price
- Cost Reimburse
- Time and Material
- Fixed Price Contracts, Fixed price (FP) contracts also called lump-sum contracts, involve a predetermined fixed price for the product and are used when the product is well defined. Therefore, the seller bears a higher burden of the cost risk than the buyer. This type of contract is used when there is no uncertainty in the scope of work. Once the contract is signed, the seller is contractually bound to complete the task within the agreed amount of money and/or time There are 3 types of contracts in this category:
A. Firm Fixed Price (FFP) this is the simplest type of procurement contract, means that buyer will going to pay one amount regardless of how much it costs the contractor to do the work. A fixed price contract only makes sense in cases where the scope is very well known. If there are any changes to the amount of work to be done the seller doesn’t get paid any more to do it, unless the scope of the work changes. A Firm Fixed-Price contract is mostly used in government or semi-government contracts where the scope of work is specified with every possible detail outlined. A drawback of a Firm Fixed-Price contract is possible disputes between the buyer and the seller if the scope is not clear. Moreover, any deviation from the original scope can cost you a lot, an example of this contract will be like “ the seller has to complete the job for 80,000 USD within 12 months “
B. Fixed price plus incentive fee (FPIF)is a complex type of contract in which the seller bears the higher risk. There is a financial incentive tied for achieving agreed metrics. Typically such financial incentives are related to cost, schedule or technical performance of the seller. Performance targets are established at the outset of the project and final contract price is decided after completion of the project based on the seller’s performance. For every dollar saved by the seller which reduces the cost below the original estimated target, the cost savings are split between the seller and buyer based on a share ratio (similar to CPIF). In case the cost exceeds there is a price ceiling, and all costs above the ceiling are the responsibility of the seller, therefore if costs exceed the ceiling, the seller receives no profit, an example of this contract will be adding a clause into the contract such as “8,000 USD will be paid to contractor as an incentive if he completes the work before two weeks from the agreed upon date “
C. Fixed Price Economic Price Adjustment (FPEPA) is a fixed price contract which allow for price increases if the contract is for multiple years. It is a fixed price contract but with a special provision allowing for pre-defined final adjustments to the project contractprice due to change conditions, such as inflation, cost increases (or decrease) due to specific commodities. The FPEPA is intended to protect both buyer and seller from external conditions beyond their control, an example of this type will be adding a clause like “ About 2% of the cost of the project will be increased after a certain time duration based on the USD/EUR Conversion rate “
2. Cost Reimbursable, This contract is also known as a Cost plus contract. In this type of contract, the seller is reimbursed for completed work plus a fee representing his profit. Sometimes this fee will be paid if the seller meets or exceeds the selected project objectives. This type of contracts is usually used when there is uncertainty in the scope, or the risk is higher. Therefore, the buyer bears the highest cost risk,. The major drawback of this type is the scope creep, especially when the requirements are uncertain or unclear. The seller will always try to elevate the cost because it will be tied to some sort of fee or reimbursement, Common forms of cost reimbursable contracts include:
A. Costs plus fixed fee (CPFF) or Cost Plus Percentage of Costs (CPPC)means buyer will pay the seller back for the costs involved in doing the project work, plus a fixed fee that buyer will pay on top of that. If this agreed amount or fixed fee is calculated as percentage of the initial estimated project costs it is referred as Cost plus Percentage of Costs (CPPC) type of contract. This fee does not change with seller’s performance. However fee amount can change if the project scope changes. An example will be like adding a clause of “ The Seller will be paid the Invoiced costs of the project in addition to a $20,000 Fee “ OR “ The seller will be paid the invoiced costs of the project plus 15% of those costs “ .
B. Costs plus incentive fee (CPIF)means buyer will reimburse the costs of the project and pay a pre-determined fee if seller meets certain performance goals or any other specific performance target as decided in the contract, usually represented in terms of time/cost. In CPIF if the final costs are less or more than the original estimated costs, then both the buyer and seller will share the costs based on pre negotiated sharing formula, which called “ Sharing Ratio Ex:60/40 “. In a Cost plus Incentive Fee contract, the incentive is a motivating factor for the seller. If the seller is able to complete the work with less cost or before time, he may get some incentive.
C. Costs plus award fee (CPAF) is similar to the Cost Plus Fixed Fee(CPFF) contract, except that instead of paying a fee on top of the costs, buyer agrees to pay a fee based on the buyer’s evaluation of the seller’s performance. You should understand there is a difference between Incentive Fee and Award Fee, an incentive fee is calculated based on a formula defined in the contract, and is an objective evaluation. An award fee is dependent on the satisfaction of the client and is evaluated subjectively. Award fee is not subjected to an appeal.
3. Time and Materials Contract
Time and material (T&M) contracts (sometimes called Unit Price Contracts). This is a hybrid contract of Fixed-Price and Cost Reimbursable contracts. Here, the risk is distributed to both parties. A Time and Materials type of contract is generally used when the deliverable is “labor hours.” In this type of contract, the project manager or the organization will provide the required qualification or experience to the contractor who is responsible for providing the staff. This type is usually used to hire some experts or any outside support, here; the buyer can specify the hourly rate for the labor with a “not-to-exceed” limit. A simple example will be that a skilled labor will be paid $15 per hour.
Risk and Contract Type
Below am listing the contracts in a way you can easily understand who carries more risk in each type of contract, the buyer or the seller.
The risk on the buyer will be the maximum at a Cost Plus Percentage of Costs (CPPC) contract, the seller will carry the maximum risk in a fixed price contract.
Buyers’ cost risk from the various contract types (from highest to lowest):
CPPC –> CPFF –>CPAF –> CPIF –>T&M –>FPEPA —> FPIF –> FFP