If you are managing a project that uses vendors or contractors, you will to have a contract. There are two types of incentive fee contracts in the PMBOK guide: Cost Plus Incentive Fee (CPIF) and Fixed Price Incentive Fee (FPIF) contracts. When there is an incentive fee, the seller will be awarded a bonus if they meet specific performance criteria (usually cost related).
Some examples of performance criteria include:
- Completing project below $50,000
- Product uptime is 99.99%
- Project is finished in 10 weeks
(Read about Automating Procurement here)
In this post, we will cover the 7 formulas that you will to know to calculate the incentive fees for CPIF and FPIF. Before we get started, let’s define all of the terms you will need to know:
Target Cost – A projected cost of the project agreed upon by the buyer and the seller before project work begins. This is the buyer’s budget for the project.
Actual Cost – The actual cost of the project calculated after the project is completed. This is the sum of the project costs plus the fees paid to the seller.
Target Fee – A fee paid to the seller if the work is completed at Target Cost.
Cost Variance – The difference between Target Cost and Actual Cost. Positive variance is good.
Share Ratio – The ratio of dividing the Cost Variance between the buyer and the seller.
Formula 1: Price = Cost + Fees
This is the basic formula for FP contracts where the price is estimated before work begins. The price is determined by adding the cost plus a fee.
Formula 2: Cost Variance = Target Cost – Actual Cost
The cost variance is the difference between Target Cost and Actual Cost. If the variance is positive, it is good. Negative variance is bad for both the buyer and the seller.
Formula 3: Buyer’s Share = Cost Variance * Buyer’s Share Ratio
The buyer and the seller will split the cost variance in an incentive fee contract. The buyer’s share ratio will be pre-determined in the contract. The buyer’s share represents the extra savings or extra costs that the buyer incurs.
Formula 4: Seller’s Share = Cost Variance * Seller’s Share Ratio
The seller’s share represents the percentage of the cost variance that will be paid to or paid by the seller. If the seller’s share is positive, the seller will make a bonus on top of their fees. If the seller’s share is negative, the seller will make less money than their pre-determined fees. The seller’s share ratio is determined in the contract before the project begins.
Formula 5: Buyer’s Share Ratio + Seller’s Share Ratio = 1
The sum of the buyer’s share ratio and seller’s share ratio equals 1.
Formula 6: Fee = Target Fee + Seller’s Share
The total amount of money paid to the seller is the sum of the Target Fee plus Seller’s Share. The Target Fee is pre-determined, and the Seller’s Share is based on whether the seller is able to meet pre-determined performance criteria.
Formula 7: Total Price = Actual Cost + Target Fee
The total cost of the project paid by the buyer is the sum of the Actual Cost plus the Target Fees.
Incentive Fee Example
Let’s assume you are the buyer. Your company wants you to manage a development project and gives you a budget of $400,000. Thus, your Target Cost is $400,000.
You post an Request for Proposals (RFP) and held a Bidder’s Conference to solicit potential sellers. After you obtained 10 responses, you select the most qualified candidate. Once the candidate is selected, you negotiate and agree upon a fixed price of $40,000 for the work they complete and reimburse them for any costs they incur. In other words, Target fee is equal to $40,000.
Let’s look at the price you will pay without any incentive fees:
|Actual Cost||Target Fee||Total price|
As you can see from the chart above, since the seller has no incentive to lower costs, you will likely experience a cost overrun because the seller will be paid the same amount no matter how much the project costs.
Now let’s look at a scenario where there’s an 60/40 incentive fee share ratio. (Note: the incentive fee share ratio is always written with the buyer’s share first followed by the seller’s share. In other words, 60% is the buyer’s share and 40% is the seller’s share.)
|Actual Cost||Target Fee||Seller’s Share||Total price|
|$360,000||$40,000||(400,000 – 360,000) * 0.4 = $16,000||360,000 + 40,000 + 16,000 = $416,000|
|$400,000||$40,000||(400,000 – 400,000) * 0.4 = $0||400,000 + 40,000 + 0 = $440,000|
|$440,000||$40,000||(400,000 – 440,000) * 0.4 = -$16,000||440,000 + 40,000 – 16,000 = $464,000|
|$500,000||$40,000||(400,000 – 500,000) * 0.4 = -$40,000||500,000 + 40,000 – 40,000 = $500,000|
As you can see, when there’s an incentive fee, the seller is motivated to complete the project below the budget, or the Target Cost. If they go over the budget, they will receive less fees. If they go under budget, they will receive more profits. When there’s rewards and penalties built into the final price, the seller has more incentive to meet your performance criteria.
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