Contract Types

Contract types is one of the tools & techniques of Plan Procurements. Whenever you are getting into an agreement with a supplier outside the organization for any procurement, you will be signing the contracts. Any legal contractual relationships generally fall into the following categories -

1. Fixed Price Contracts
2. Cost Reimbursable Contracts
3. Time & Materials Contracts
   

There are pros & cons for each type of contracts. Let's try to understand each one of this by getting into the details of each contract.

Fixed Price Contracts - These type of contracts are negotiated at fixed total price. In such contracts, the scope of work has to be clearly defined. There are provisions of incentives also in these contracts if the requirements stated in the scope of work exceed any quantifiable measurements. On the other hand, if the completed work does not meet the defined standards or any other quantifiable measurement, damages are borne by the seller. In such type of contracts, the seller is at the higher risk.

As per PMBOK Guide 4th Edition, there are three types of fixed price contracts -

• Firm Fixed Price Contracts (FFP) - In this type of contract, the fee is fixed for the products or services. No incentives are given while cost overruns are borne by the seller. Seller is at the highest risk here. Scope of work has to be very clearly defined for such type of contracts. One of the example for this type of contract can be - a purchase order for delivering an off the shelf product for a specified price by a specific date.
  
• Fixed Price Incentive Fee Contracts (FPIF) - In such contracts, incentives are given to the seller in case the pre defined performance targets are met or exceeded. The performance targets & the financial incentives are decided before the start of the work. In order to safeguard seller's interest, price ceiling is also decided. Any cost above the ceiling is borne by the seller. These contracts motivate sellers to try and get the incentives by way of over performing. One of the example for this type of contract can be - the seller will be given additional 5% of the total price if the required software product is delivered 2 weeks earlier than the specified scheduled date.
  
• Fixed Price with Economic Price Adjustment Contracts (FP - EPA) - These type of contracts are usually signed where the project duration is spanning over the years. This safeguards the interest of both buyer & seller against any external conditions beyond their control e.g. inflation rate, currency exchange rate fluctuation in case of outsourced projects.

Cost Reimbursable Contracts - These type of contracts are aimed at de-risking the sellers from cost point of view when the scope of work is not clearly known at the start and can change as the work progresses. In such contracts, sellers are paid the actual cost incurred to accomplish the work along with seller's profit. In these type of contracts, buyer is at a higher risk as the total cost is not known at the start of the work.

As per PMBOK Guide 4th Edition, there are three types of cost reimbursable contracts -

• Cost Plus Fixed Fee Contracts (CPFF) - In these contracts, the seller is reimbursed the actual cost of performing the work and a fixed fee. This fixed fee is calculated as a percentage of the initial estimated cost. Fixed fee does not change with actual cost.
• Cost Plus Incentive Fee Contracts (CPIF) - In these contracts, the seller is reimbursed the actual cost of performing the work & the incentive fee. This fee is based upon the performance of the seller. Performance is determined based on the pre-defined performance targets.
• Cost Plus Award Fee Contracts (CPAF) - In this type of contract, all the cost of performing the work is reimbursed plus the incentive (award) is given to seller based upon its performance. The point to note here is that - subjective evaluation is done for seller's performance.
• Cost Plus Fee (CPF) Or Cost Plus Percentage of Cost (CPPC) - In this type of contract, seller is paid the actual cost of completing the work plus a fee. This fee is calculated as a percentage of actual cost of completing the work. Percentage is pre-determined but the fee will vary with the actual cost.
  

Time & Material Contracts (T&M) - These type of contracts are mix of cost-reimbursable and fixed price contracts. Generally, the project durations are longer, scope of work is not clearly known at the start. It resembles cost-reimbursable in a way because the actual cost is not known in advance and resembles fixed price in the sense that unit rate for the labor and/or material is agreed upon at the start of the work.