Procurement contract types are an important part of Procurement Management in the PMBOK® guide, and you will get a few questions on the topic on your PMP® exam. In this post, we will what the 3 major types of contracts explained in the PMBOK®:
- Fixed price contract
- Firm fixed price contract (FFP)
- Fixed price with economic price adjustment contract (FP-EPA)
- Fixed price incentive fee contract (FPIF)
- Cost reimbursable contract
- Cost plus fixed fee contract (CPFF)
- Cost plus percentage fee contract (CPPF)
- Cost plus incentive fee contract (CPIF)
- Cost plus award fee contract (CPAF)
- Time and material contract
Fixed Price Contract (FP)
Fixed price contracts is sometimes also called lump sum contracts. Like its name suggests, the buyer will pay the seller a fixed amount of money for the work specified in the contract. The contract is signed by both parties before project work begins.
A fixed price contract is used when the scope is well defined. The buyer and seller understand how much time and resources are need to complete the project. The scope and budget can only be changed through formal change control procedures.
If the seller spends more money or labor than anticipated to complete the project, they are not going to be reimbursed for the extra costs. Since the FP contract is legally binding, the seller must complete the project even if they are losing money. Thus, the risk in a Fixed Price contract is on the seller.
Firm Fixed Price Contract (FFP)
The FFP is the most common type of the fixed price contract. In a FFP contract, the buyer will pay the price specified in the contract, regardless of the cost incurred by the seller. Since the risk is on the seller, the seller has great incentive to complete the project as cheaply and as quickly as possible.
Here are two diagrams illustrating the relationship between price paid by buyer, cost incurred by seller, and profits earned by seller:
Source: http://www.pmbypm.com/firm-fixed-price-contract/
Fixed Price with Economic Price Adjustment Contract (FP-EPA)
The FP-EPA contract is a variation of the FP contract, where the seller is able to adjust the price of the contract based on economic factors.
These factors must be predefined and agreed upon by both parties before the contract is signed. These factors are economic factors outside of the control of the buyer and seller.
Here’s 2 examples when FP-EPA contracts will be useful:
- If oil is a major input to the project and the price of oil suddenly shot up, the seller is able to adjust the price of the contract based on the new increased prices of oil.
- If the project is multinational and the currency or interest rate of one country suddenly increased, the seller is able to adjust the project prices to relate the increased costs.
FP-EPA contract is most often used for fixed price contracts spanning multiple years. There is a direct correlation between uncertainty and length of a project. Because so many factors can change the market in the future, the seller needs to protect themselves by being able to increase the price of the project to adjust for market conditions.
One downside of using FP-EPA contract is that there can be a lot of administrative work involved to implement this type of contract. However, the benefits for the seller to adjust the prices to match economic conditions outweigh the extra admin work involved.
The formula to for FP-EPA is:
New price of contract = old price of contract * (1 + inflation rate)
Fixed Price Incentive Fee Contract (FPIF)
The FPIF contract is a variation of the FP contract where there is some price flexibility built in. The buyer and seller will agree upon performance incentives during negotiations, and if the seller is able to meet the required performance incentives, they will be paid a bonus.
On the flip side, the FPIF can also include a negative incentive. If the seller is unable to meet the performance standards, they can also receive a penalty.
In a FPIF contract, the final price is calculated after all the work has been completed.
Examples of performance criteria:
- Product is finished in 6 weeks
- Software uptime is 99.99%
- Project is completed under $500,000
Cost objectives is the most common type of performance criteria. If the seller completes the project below the target cost, they will receive an incentive from the buyer. Both party wins.
(Read about about Incentive Fee contract calculations here.)
Cost Reimbursable Contracts
In cost reimbursable contracts, the buyer will reimburse the seller for all eligible costs plus a fee, which represents the seller’s profits. In other words, the formula for cost reimbursable contracts is:
Cost of project = cost incurred by seller + agreed upon fees
Cost reimbursable contracts are used when the scope is not fully defined at the start of the project. If there is an unanticipated cost overrun, the buyer is responsible for covering that cost. Thus, the risk in cost reimbursable contracts is on the buyer.
Cost plus fixed fee contract (CPFF)
This type of cost reimbursable contract is the most straightforward. In CPFF, the seller will reimburse the buyer for all allowable costs plus a pre-determined fee, which represents the seller’s profits.
Cost plus award fee contract (CPAF)
In CPAF contract, the buyer reimburses the seller for all allowable costs plus they may choose to give the seller an award based on a set of subjective factors. Think of the award as a tip given based on how much the buyer liked the seller.
Cost plus incentive fee contract (CPIF)
In CPIF, the buyer will reimburse the seller for all allowable costs plus an incentive fee determined based on some predefined performance criteria (usually cost-related).
(Read how to calculate incentive fee contract here.)
Time and Material Contract (T&M)
In a T&M contract, the unit cost of labor or material is fixed, but the number of units is flexible. For example, the contract will fix a consultant’s rate to be $100/hour, but the number of hours the consultant works on the project may vary.
The basic formula for T&M = rate of resource * unit of resource used
A T&M contract is a hybrid between a fixed price contract and cost reimbursable contract. It is sometimes also called Rate Contract or Unit Price Contract.
This type of contract is used when the scope is broadly defined, and there is a high probability of changes to the scope.
In a T&M contract, the buyer and seller share the risk of the contract. The buyer knows the predetermined rates of resources, and the seller can claim extra units delivered if the scope increases.