Procurement Management Process helps us to identify suitable suppliers/contractor for product delivery or provide proper services or equipment lease. A project manager must have good understanding on procurement concepts, no matter whether he is a buyer or seller. Contract type is one of the tools & techniques to plan procurement. Generally when a procurement happens, a legal document gets sign off between the buyer and the seller. This contractual relationship usually falls into following categories –
- Fixed Price Contract
- Cost Reimbursement Contract
- Time & Material Contract.
Let’s get in to the detail of these contract types…
Fixed Price Contract: These type of contracts usually take place when the scope of work is clearly define. Once the contract is signed, seller is legally bound to complete the work within the agreed time or money. So the seller is at the higher risk. However there are also provision of incentives in these contracts if the quantifiable parameters mentioned in scope of work exceed in certain level as defined and agreed between buyer and seller.
According to PMI, there are three types of fixed price contract.
Firm Fixed Price Contract (FFP) – This is a straight forward and simplest contract. In this type of contract, price or fee is fixed for the products or services. The scope of work is well defined and there is no incentives. Seller is at the highest risk. Any additional cost or time due to bad performance of seller must be borne by the seller. A typical example of fixed price contract can be – a purchase order given to seller for delivering 10 printer cartridges on a specific date.
Fixed Price Incentive Free Contracts (FPIF) – In such contract there is a provision of incentive for the seller based on the pre-defined performance. If the seller meet or exceed the agreed pre-defined performance, s/he gets the incentive. The incentive can be tied to any project metrics such as cost, time or performance. An example can be – 10% of total contract value will be paid to the contractor as incentive if s/he can complete the deployment of ERP within two months.
Fixed Price with Economic Price Adjustment Contracts (FP-EPA) – This type of contracts are long term contract, typically span over the year or multiple years. To safeguard both buyers and sellers interest from external conditions that are beyond their control, such as Inflation, Exchange rate etc, special provision is kept as contract clause. Example of this contract is – 8% of contract value will be increase in every three years base on SLA performance for ten years contract.
Cost Reimbursement Contract – When scope of work is uncertain or can change as the work progress, this type of contract is use. In such contract, sellers are paid the actual cost to accomplish the work along with profit. As the scope of work is not known hence cost is also unknown, buyers are in higher risk.
As per PMI, there are four types of Cost Reimbursement Contract –
Cost Plus Fixed Fee Contract (CPFF) – In this type of contract sellers are paid the cost incurred to complete the work plus a fixed agreed fee. This fee is decided as percentage of initial cost or fixed amount. In such contract buyer is in highest risk as the fee remain unchanged regardless of seller’s performance. Example: Total cost to build a web site plus 2% fixed fee on total cost.
Cost Plus Incentive Fee Contract (CPIF) – In cost plus incentive fee contract, seller is paid the total cost of the work plus an incentive based on gaining certain performance. Performance measurement parameters are determined based on pre-define performance targets. An example can be – 20% of total project cost will be paid to the seller if the project gets delivered within two months and with 5% less cost.
Cost Plus Award Fee Contract (CPAF) – In such contract, all cost of work is paid to the seller plus some award fee. Award fee is determine based on the buyer’s satisfaction on certain performance of seller. Here to note that incentive fee and award fee are totally different. Incentive fees are calculated based on the KPI measurement formula given in contract. Whereas award fee is based on buyer’s satisfaction and it is a subjective evaluation. An example can be – if a seller can meet certain quality standards while deploying a solution, s/he will be paid award up to $10,000.
Cost Plus Percentage of Cost Contract (CPPC) – In this type of contract seller is paid all cost of work plus a pre-determined percentage of total cost. This type of contract is not preferable as the seller may take the chance to artificially raise cost to gain higher profit. Example: Total cost plus 10% of cost to seller.
Time and Materials Contract – This is a hybrid contract, mix of fixed price and cost reimbursable contract. Here risk is distributed to both parties. This type of contracts are in use when project duration is long, scope of work is not clear in start and deliverables are in fixed i.e. time or materials. Example: Technician will be paid $30/hour
Selecting right contract type is an important decision for a project manager. Right selection of contract will increase the performance of the project and will also mitigate risks.
That’s all folks……..!
ref : PMBOK, PMP Study