Within this blog post we will discuss various types of procurement contracts used in project management.
Procurement management helps you identify a suitable supplier or contractor to procure goods and services. Procurement management has become a necessity for organizations, everyone must deal with it at some point in their business life.
As a project manager you must understand the procurement concepts, regardless of whether you are a buyer or a seller. Moreover, procurement contracts are used in almost every organization whether they are projectized, functional, or matrix.
Before we go any further, let’s review the definition of procurement.
As per Wikipedia:
Procurement is the acquisition of goods, services or works from an external source. It is favorable that the goods, services or works are appropriate and that they are procured at the best possible cost to meet the needs of the purchaser in terms of quality and quantity, time, and location.
There can be many reasons for you to require procurement, such as:
- You may go for a procurement contract when you don’t have the expertise to carry out the job.
- You don’t have the capability to do it on your own.
- You lack the capacity to handle the requirement.
- A resource can be procured outside your firm at a significant discount.
You may require a procurement to buy some goods from an outside source to fulfill your requirements: for example, purchasing hardware items and equipment.
You may also hire a service, for example, you can hire a consultant to help you find drawbacks in your process and suggest ways to improve them.
However, before going for a procurement contract, you must analyze whether it would be cost-effective to do it yourself or if you should outsource it. If the benefits of outsourcing outweigh the “do it yourself”, you should outsource it.
For example, you are constructing a building for your office and you don’t have the expertise for electrical work. You have two options to complete the project: do it yourself by training or placing experts on payroll, or contract an outside firm who already is an expert in this task.
Of course, the second option is better because it helps you save money, time, and the headache of training your staff for this job. Because of procurement, life has become easier for organizations. Organizations can focus on their core business and the rest can be outsourced.
Procurement helps companies share the opportunity, hire the expertise, and buy the goods or services.
Gone are the days when organizations did every process they needed. These days, they perform the functions in which they are the best, and the rest they outsource.
It is well known that in the early days, Ford Motors used to grow soy to extract oil to use in the paint.
Nowadays, no automaker does it. If any automobile company needs paint, they will simply buy it from the open market. Likewise, they may also buy tires or many other parts and then assemble the car.
Doing everything on your own is impractical and involves processes where you cannot attain true expertise without significant costs, which may cause your product to be either substandard or over-priced. This, of course, is bad for an organization.
Because procurement is indispensable for modern businesses, procurement management is also necessary. Procurement management helps you find the best seller/supplier for your job and then negotiate an appropriate contract.
A contract is a legally binding agreement between two or more parties. Usually, one party is known as a buyer and another as a seller. The contract is the key to the buyer and seller relationship. It provides the framework for how they will deal with each other.
Procurement contracts can be broadly divided into three categories:
- Fixed-Price Contract
- Cost Reimbursable Contract, and
- Time and Materials
Please note that there is no hard-and-fast rule which governs the type of contract selected for any particular situation. As a project manager, it will be your job to select a contract type to satisfy your needs.
A Fixed-Price Contract is also known as a lump-sum contract. This type of contract is used when there is no uncertainty in the scope of work. Once the contract is signed, the seller is contractually bound to complete the task within the agreed amount of money and/or time. Due to the nature of the contract, the seller bears the majority of the risk, as he must provide for the completion of the work as stipulated in the contract
A Fixed-Price Contract can be further divided into three categories:
- Firm Fixed-Price Contract (FFP)
- Fixed Price Incentive Fee Contract (FPIF)
- Fixed Price with Economic Price Adjustment Contracts (FP-EPA)
The main advantage of Fixed-Price Contract is that both parties know the scope of the work, and the total cost of the task before the work is started.
Generally, outsourcing and turnkey procurement contracts are signed under a fixed-price contract on a deliverables basis.
This type of contract is very useful if the scope of work is defined accurately. Fixed-price contracts are good for controlling the cost.
However, changes in scope must be carefully observed. The cost of any change in scope is very steep in fixed-price contract. I have seen that the contractors get the contract by bidding the lowest price, then try to generate extra revenue on any opportunity for change requests, such as added scope.
I have also seen contractors fighting with the project manager regarding the scope. Although they agreed initially, later they argue on small issues to raise the change request to earn some extra money.
For this reason, you have to be very careful with this type of contract, make sure that the scope is as detailed as well-defined and detailed as possible.
Firm Fixed-Price Contract (FFP)
This is the simplest type of procurement contract. In this type of contract, the fee is fixed. The seller has to complete the job within an agreed amount of money and time. Any cost increase due to bad performance of the seller will be the responsibility of the seller, who is contractually bound to complete the job within the agreed amount.
A Firm Fixed-Price Contract is mostly used in government or semi-government contracts where the scope of work is specified with every possible detail.
This type of contract is easy to float on the market, receive bids, and evaluate the bids primarily on a cost basis.
Since the risk is borne by the seller, the cost tends to be higher. Another drawback of a Firm Fixed-Price Contract is possible disputes between the buyer and the seller if the scope is not clear. Moreover, any deviation from the original scope can cost you a lot.
Example: The seller has to complete the job for 100,000 USD within 18 months.
Fixed-Price Incentive Fee Contract (FPIF)
In this type of contract, although the price is fixed, the seller is given an additional incentive based on his performance. This incentive lowers the risk borne by the seller.
The incentive can be tied to any project metrics such as cost, time, or technical performance.
Example: 10,000 USD will be paid to contractor as an incentive if he completes the work before two months.
Fixed-Price with Economic Price Adjustment Contracts (FP-EPA)
If the contract is multi-year long, a Fixed-Price with Economic Price Adjustment Contract is used. Here you include a special provision in a clause which protects the seller from inflation.
Example: About 3% of the cost of the project will be increased after a certain time duration based on the Consumer Price Index.
Purchase Order (PO)
This type of contract is used to buy commodities.
Example: Buy 10,000 bolts at the cost of 1.00 USD.
Cost Reimbursable Contract
This contract is also known as a Cost Disbursable Contract. In this type of contract, the seller is reimbursed for completed work plus a fee representing his profit. Sometimes this fee will be paid if the seller meets or exceeds the selected project objectives; for example, completing the task before time or completing the task with less cost, etc.
A Cost Reimbursable Contract is used when there is uncertainty in the scope, or the risk is higher. In this contract, since the buyer pays for all cost, he bears the risk.
Scope Creep is an inherent drawback of a Cost Reimbursement Contract, especially when the requirements are unclear. The seller will always try to elevate the cost because it will be tied to some sort of fee or reimbursement.
This difficulty can be minimized with proper management of the contract and capping the seller’s profit; e.g. 10% of the total cost.
Cost Reimbursable Contracts can be further divided into four categories:
- Cost Plus Fixed Fee Contract (CPFF)
- Cost Plus Incentive Fee Contract (CPIF)
- Cost Plus Award Fee (CPAF)
- Cost Plus Percentage of Cost (CPPC)
A Cost Reimbursable Contract provides you with better cost control when you don’t have a well-defined scope.
Cost Plus Fixed Fee Contract (CPFF)
In this type of contract, the seller is paid for all incurred costs plus a fixed fee (which will not change), regardless of his performance. Here, the buyer bears the risk.
This type of contract is used in projects where risk is high, and no one is interested in bidding. Therefore, this type of contract is selected to keep the seller safe from risks.
Example: Total cost plus 25,000 USD as a fee.
Cost Plus Incentive Fee Contract (CPIF)
In a Cost Plus Incentive Fee Contract, the seller will be reimbursed for all costs plus an incentive fee based upon achieving certain performance objectives mentioned in the contract. This incentive will be calculated using an agreed on predetermined formula.
Here the risk also lies with the buyer; however, this risk is lower than the Cost Plus Fixed Fee where the buyer has to pay a fixed fee along with the cost incurred.
In a Cost Plus Incentive Fee Contract, the incentive is a motivating factor for the seller. If the seller is able to complete the work with less cost or before time, he may get some incentive.
Most of the time the incentive is a percentage of the savings, which is shared by the buyer and the seller.
Example: If the project is completed with under budget, 25% of remaining fund will be given to the seller.
Cost Plus Award Fee (CPAF)
Here, the seller is paid for all his legitimate costs plus some award fee. This award fee will be based on achieving satisfaction according to certain performance objectives described in the contract.
The evaluation of performance is a subjective matter, and you cannot appeal it.
Note: There is a difference between the incentive fee and the award fee. An incentive fee is calculated based on a formula defined in the contract, and is an objective evaluation. An award fee is dependent on the satisfaction of the client and is evaluated subjectively. Award fee is not subjected to an appeal.
Example: If the seller completes the task meeting or exceeding all quality standards, based on his performance he may be given an award of up to 10,000 USD.
Cost Plus Percentage of Cost (CPPC)
Here the seller is paid for all costs incurred plus a percentage of these costs. This type of contract is not preferred buy the buyer because the seller might artificially increase the cost to earn a higher profit.
Example: Total cost plus 15% of cost as a fee to contractor.
Time and Materials Contract
This is a hybrid contract of Fixed-Price and Cost Reimbursable Contracts. Here the risk is distributed to both parties.
A Time and Materials type of contract is generally used when the deliverable is “labor hours.” In this type of contract, the project manager or the organization will provide the required qualification or experience to the contractor who is responsible for providing the staff.
This type of contract is used to hire some experts or any outside support.
Here the buyer can specify the hourly rate for the labor with a “not-to-exceed” limit.
Example: Technician will be paid 20 USD per hour.
Selecting the contract type is a very important decision for a project manager. It determines your relationship with the seller and mitigates risk.
You should always select a contract which provides the optimum value for your time and money, and protects your project from any risks. If the scope of work is well defined and fixed, you should go for the Fixed-Price Contract. However, if the project scope is not fixed and is exploratory, you should choose the Cost Reimbursable Contract.
If you require only expert opinions, consultancy service or outside support, you should go for the Time and Materials type of contract.