How Many Types of Contracts Are Out There?
Fundamentally, 2. Then there is a third, hybrid approach. The first two have few variations.
- Fixed Price
- Cost Reimbursable
- Time & Material
Contract management is a crucial part of project manager’s duties. However, this does not mean she takes care of this single-handed.
Worried about mistakes you can make while drafting a contract? Don’t miss the infographic at the end of this post about 10 mistakes that can void a contract!
Contract has legal implications, and needs to be handled by experts. It is highly recommended for the PM to involve Finance dept, if there is no dedicated contract management body in the organization, while dealing with procurement.
Let us take a closer look at different types of contracts.
1. Fixed Price Contract
The basic version of this contract involves buyer paying a fixed sum to the seller for producing a product or service. The variations of this contract involve paying additional money based on certain criteria. Under this contract seller is legally obligated to complete the work as per defined acceptance criteria. If not they will have to pay financial penalties. Hence this is mostly favored by the buying organization, and not many sellers would like this type of contract.
What happens to the contract when there is a change in scope midway the project?
You update the contract with additional scope, rework the price increase (or decrease, as the case may be) and update contract with pricing and delivery details.
Firm Fixed Price contract (FFP)
This is most commonly used Fixed Price contract type. The price of product or service is fixed upfront and will change only if there is change in scope – as agreed by both seller and buyer. If initial estimates were found to be incorrect then seller assumes all additional cost.
Fixed Price Incentive Fee contract (FPIF)
Apart from the fixed price of the contract, seller gets a chance to make more money if predetermined performance metrics are achieved. These metrics could be related to cost, schedule or technical performance.
Fixed Price with Economic Price Adjustment contract (FP-EPA)
This is a favored contract type for long term projects that span years. The price adjustment comes into play due to factors such as inflation, cost changes to raw materials, or changed environmental conditions under which the project is carried out.
Many infrastructure projects (such as construction of highways or dams) use this contract.
2. Cost-reimbursable Contract
Buyer reimburses all legitimate costs incurred in carrying out the contract work by the seller. In addition, buyer pays a fee which is the profit component of seller.
The fee may be fixed or tied to certain performance expectations, such as cost, time, or quality of the deliverables.
Cost Plus Fixed Fee contract (CPFF)
This is a straight forward case of reimbursement of costs and a fixed fee. In some cases this fee could be certain percentage of the initial fixed price quoted, or certain percentage of the overall cost subject to a ceiling limit.
Cost Plus Incentive Fee contract (CPIF)
Apart from the fixed cost component, additional incentive fee is subject to achieving performance objectives as written in the contract.
Cost Plus Award Fee contract (FPAF)
This is similar to CPIF type of contract, with a difference that award fee is subject to achievement of certain performance aspects which are subjective, rather than objective. These are not clearly measurable and amount of award fee is determined by the buyer purely based on how happy she is with the deliverables.
These types of contracts are managed in conduct procurements process.
3. Time and Material Contract (T&M)
The third type of contract to consider in contract management process is a hybrid.
This type of contract contains elements from both Fixed Price and Cost-reimbursable contracts.
Buyer pays seller for all the materials needs to carry out the work (hardware, machinery, tools and equipment) and pays a per unit rate for the time spent carrying out the work by the project team.
If the requirements are subjected to changes quite often, where buyer himself is not able to decide on requirements upfront, this is the contract type to go.
Many new software products are built using this contract type.
This is because a software product is built with a basic set of features determined by the end user research and then the product requirements evolve based on how end users use it.
For this reason the full value of contract cannot be determined accurately up front. Sometimes they have clauses on the ceiling amount for the material cost, and a time limit for complete delivery.
Majority of projects that I have worked with have been on Time & Material contract type, as it is usually the norm with new product development projects. Couple of my projects were on Firm Fixed Price contract (it puts additional pressure on the project manager) and Cost Plus Fixed Fee (CPFF).
10 Mistakes that can void a contract
This infographic explains mistakes to avoid during Contract Management Process. Courtesy: agreements.org
What is your experience with contract management process and which of these contract types have you worked with and which one do you think is better than the rest? Leave your comments below..
Have you wondered how procurement is conducted?
