In this blog post we will be discussing project procurement management but more specifically the different types of contracts that can be used within procurement management. This is a very important topic to understand because as a project manager you will be one of the people deciding which contracts to use and when. So strap in because you’re gonna learn a lot today!
Contracts are an important part of procurement within a project. This is because during a project you will definitely need different materials and technologies that you might not have beforehand. Contracts come into play when you are getting these materials and technologies from other companies. Now there are three broad categories of contracts that can be created that we will go over and within each of these categories, we will be discussing more specific contracts that are included within these broad categories. It is also important to understand who incurs the most risk in any given contract so that is another thing that we will be discussing with each type of contract. Let's get to it.
Fixed-price or lump-sum contracts
This is the first broad category of contracts that we will cover. Now these contracts “involve a fixed total price for a well-defined product or service” (Schwalbe). In this contract, the person that incurs the least amount of risk would be the buyer because there is already a fixed price. The sellers must incur the most amount of risk in this scenario because they are the one setting the price so they must do it accurately so they do not lose money on the products. Something that is common in this contract however, is that the seller will pad their estimate most of the time to reduce the risk that they incur.
Take for example that a company needed a hundred computers with certain specs that had to be met and they wanted the computers within a month. As you can see, there is a set product and delivery date that must be followed in a contract. Now sellers will have to create estimates for this product and delivery date that is competitive so that they might be the one awarded the contract.
There are other types of contracts within the category of fixed-price, this includes FFP contracts (firm-fixed-price), FPIF contracts (fixed-price incentive fee), and a FP-EPA contract (fixed-price with economic price adjustment).
Firm-fixed-price (FFP): This is exactly the type of contract we were discussing before. Out of these contracts, this one has the least amount of risk incurred by the buyer.
Fixed-price incentive fee (FPIF): This type of contract includes an incentive fee that will be paid if the product or service is delivered within a set earlier time frame than that contract sets. Take for example the computers that we were discussing beforehand. If the seller gets the computers to the buyers within two weeks instead of a month, they could be awarded an incentive fee. In this contract there could also be a Point of Total Assumption (PTA). The PTA is the “cost at which the contractor assumes total responsibility for each additional dollar of contract cost” (Schwalbe). This contract has the second-most amount of risk in this category of contracts but it is still not a very high risk.
Fixed-price with economic price adjustment (FP-EPA): This type of contract is a very interesting one, it allows for a special provision in the contract that has “predefined final adjustments to the contract price due to changes in conditions such as inflation or the cost of specific commodities” (Schwalbe). This type of contract is intended to protect both the buyer and seller from uncertain economic factors that neither side have any control over.
Cost-reimbursable contracts
The next category of contracts that we will go over is cost-reimbursable contracts. These contracts “involve payment to the supplier for direct and indirect actual costs” (Schwalbe). The tricky thing about this type of contract is the inclusion of indirect cost. You can find another blog on our site that talks about the differences between direct and indirect costs but here is a very short summary of indirect costs. “Indirect costs are not directly related to the products or services of the project, but they are indirectly related to performing the project” (Schwalbe). For the most part this contract will be used when “providing goods and services that involve new technologies” (Schwalbe). These types of contracts can include fees, like profit percentage or incentives for meeting objectives. For this type of contract the buyer is the one that absorbs the most risk. Here are three different types of this contract, ordered from least to highest risk for the buyer.
Cost plus incentive fee (CPIF): With this contract, “the buyer pays the supplier for allowable costs along with a predetermined fee and an incentive bonus” (Schwalbe). Another incentive that could be given to the supplier is for reducing contract costs, so if the final cost ends up being less than the expected cost then there is an agreed upon formula that determines what the incentive fee ends up being.
Cost plus fixed fee (CPFF): In this contract, “The buyer pays the supplier for allowable costs plus a fixed fee payment that is usually based on a percentage of estimated costs” (Schwalbe). Unlike the previous contract, this fixed fee payment will not change based on any factor.
Cost plus percentage of costs (CPPC): This contract makes “the buyer pay the supplier for allowable costs along with a predetermined percentage based on total costs” (Schwalbe). With this one the buyer assumes most of the risk involved because the supplier has absolutely no incentive to reduce costs but instead could be motivated to increase costs so that they might get a larger profit off of the contract.
Time and material contracts
This is the last type of contract that we will cover in this post and it happens to be “a hybrid of fixed-price and cost-reimbursable contracts”. Take for example there is an independent company providing services and specific project materials. There is a fixed fee of let's just say $60 dollars an hour for the services that are provided. Then there is also a fixed price like $15,000 dollars for any specific project materials that are provided by the supplier. The way this works is the supplier will send invoices to the buyer with the hours worked, fees for materials and a list of materials each week or month. “This type of contract is often used for required services when the work cannot be specified clearly and total costs cannot be estimated in a contract” (Schwalbe).
Conclusion
Hopefully you have gotten a good idea of the many different types of contracts that can be constructed based on the project that is being worked on. Something that can also take place is a mix of these different types of contracts, they do not have to be entirely separate from each other. This all depends on the type of project that is being worked on and those decisions will ultimately come down to you as the project manager. Good luck!
Sources
Schwalbe, Kathy. Information Technology Project Management. Available from: Yuzu, (9th Edition). Cengage Learning US, 2023.
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