fixed price contract

A fixed-price contract is the most used contract in traditional project management, especially in construction projects

Fixed-price contracts provide flexibility to both buyers and sellers. The seller is mindful of the scope of work, and the buyer can take confidence that the price is firm.

Today’s blog post will discuss fixed-price contracts, examine examples, and debate their pros and cons.

Fixed-Price Contract

You use a fixed-price contract when the scope of work is well defined. This contract is used to acquire goods, products, or services. 

Government agencies mostly use this type of contract because it benefits the buyer. Multiple prospective sellers bid for the contract, and the buyer picks the best offer with the lowest quote, ensuring a fair and reasonable price.

Fixed-price contracts are usually priced high because the seller adds contingencies for risks. If the cost exceeds the agreed price, the seller must bear the brunt under this agreement. 

With no hidden costs, buyers don’t have to worry about auditing invoices. The seller carefully reviews the Procurement Statement of Work (SOW) as this will help accurately estimate the time and cost for the work.

The buyer does not know the seller’s profit in a fixed-price contract.

If the scope is not well defined, disputes and claims can creep up that will affect the quality of the work. An undefined scope can cause cost overruns and delays. 

Any additional work costs more than the normal price of planned work; surprises are costly in fixed-price contracts. 

Construction projects, where the scope is mostly well defined, lend themselves to fixed-price contracts. They are less likely to be used in Information and Technology projects where the scope changes more often.

How Does a Fixed-Price Contract Work?

  • Fixed-price contracts are used when the requirements are well defined. 
  • The seller can promise a fixed price as the scope is clearly defined. 
  • The seller needs to factor in requirements and risks while preparing the quotation.
  • The buyer will pay a fixed amount once the seller completes the work. 
  • The seller takes ownership of any risks that occur while executing the project.
  • Fixed-price contracts use formal change requests for changes, additional work, or other terms and conditions.
  • This contract is riskier to buyers than any other type of contract since they’re paying a premium for a no-surprises.

Types of Fixed-Price Contracts

Below are different types of Fixed-Price contracts:

  1. Firm Fixed-Price Contract (FFP)
  2. Fixed-Price Plus Incentive Fee (FPIF)
  3. Fixed-Price Plus Award Fee (FPAF)
  4. Fixed-Price with Economic Price Adjustment Contract (FPEPA)
  5. Graduated Fixed-Price (GFP)
  6. Purchase Order (PO)

Firm Fixed Price Contract (FFP)

A firm-fixed-price contract means the buyer will pay the seller a fixed amount (as defined by the contract), regardless of the seller’s costs.

An example of an FFP: the seller must complete the project for 1,100,000 USD in line with all clearly described requirements.

Fixed-Price Plus Incentive Fee Contract (FPIF)

The FPIF is where the buyer pays the seller a fixed amount (as defined by the contract). The seller can earn an additional amount if the seller meets defined performance criteria.

An example of FPIF is a contract for a total project cost: 1,100,000 USD. If the project is finished one month early, an additional 10,000 USD is paid to the seller, incentivizing the seller to work faster.

Fixed-Price Plus Award Fee (FPAF)

The FPAF is another type of incentive contract where the buyer pays the fixed fee plus an award (bonus) based on performance.

For example, the total project cost is 100,000 USD. If the performance exceeds the planned level, an additional 5,000 USD is awarded to the seller.

This is like the Fixed-Price Incentive Fee (FPIF) contract, except in FPIF, the criteria is objective and outlined in the terms and conditions. In contrast, the award fee is purely a subjective criterion decided by the buyers.

Fixed-Price with Economic Price Adjustment Contract (FPEPA)

The FPEPA is a fixed-price contract with a special provision allowing for predefined final adjustments to the contract price due to altered economic conditions such as inflation changes or cost increases (or decreases) for specific commodities.

An example of FPEPA is where the project’s total cost is 1,100,000 USD, but a price increase of 5% will be allowed per year based on the Consumer Price Index. 

Graduated Fixed Price

This flexible contract shares some risks and rewards associated with schedule variance between the customer and supplier. If the supplier delivers early, they get paid for fewer hours but at a higher rate. If the supplier delivers on time, they get paid for hours worked at their standard rate. 

If they deliver late, they get paid for more hours, but at a lower rate.

Graduated Fixed Price examples:

  • If a project is finished early, 110 USD/hour is paid. The buyer is happy because work is completed early. The supplier is happy because they make a higher margin. This is a win-win situation for both parties.
  • If a project is finished on time, 100 USD/hour is paid.
  • If a project is finished late, 90 USD /hour is paid. In this case, both the buyer and the seller are somewhat unhappy since they are making less money but at a gradual and sustainable rate that hopefully will not lead to the contract being terminated.

Purchase Order

A purchase order is a simple type of Fixed Price Contract. This contract is normally unilateral (signed by one party instead of both parties). However, some buyers require the seller’s signatures on a purchase order before considering it official. 

PO is used for commodity procurements. It becomes a firm contract when the buyer accepts the terms. The seller then delivers according to those terms.

An example of a purchase order is the procurement of 50 linear meters of wood at 6 USD per meter.

Examples of a Fixed-Price Contract

Consider a construction project to build a two-story building.

The builder agreed to construct the building within a budget of 20,000 USD in 12 months and signed the contract with the buyer.

This is an example of a fixed-price contract. Here the scope is fixed, the seller knows the exact scope of work, and the buyer knows the cost.

Some other examples of fixed price contracts are as follows:

  • Purchasing vehicles for employees
  • Purchasing office supplies
  • Paying a developer to build a website

Mathematical Examples of Fixed Priced Contracts

Before we examine the following equations, let us understand a few procurement terms.

Price: This is the amount the seller charges the buyer.

Profit (fee): The amount that the seller earns after the cost.

Target Price: This compares the result (final price) with what was expected (target price). 

Sharing Ratio: This is expressed in a ratio such as 80/20. This ratio describes how cost savings or cost overruns are shared between buyer and seller. The first number represents the buyer portion, and the second number represents the seller portion.

Ceiling price: This is the highest price buyer will pay, and if any additional costs are incurred, the seller will have to absorb them, which ensures the seller has the motivation to control costs.

Point of Total Assumption (PTA): This term is used only in fixed-price incentive fee costs. This is the amount above which the seller bears all cost overruns.

PTA = ( (Ceiling Price – Target Price)/Buyer’s Share Ratio) + Target Cost

Example – 1

Target Cost of Project = 60,000 USD; seller’s fee = 15,000 USD; ceiling price = 100,000 USD; ratio is 60:40; Actual Cost = 120,000 USD. Calculate the seller’s profit or loss.

Target Price = Target Cost + Seller’s Fee = 75,000 USD.

PTA = ((100,000-75,000)/0.6) + 60,000 = 41,667 + 60,000 = 101,677.

At or above PTA, the contract price is fixed and is equal to the ceiling price. 

As the Actual Cost is 120,000 USD, but PTA is 101,677, and the ceiling price is 100,000, and all costs above 100,000 will be borne by the seller (-20,000 USD).

Here is a more detailed explanation of the seller’s profit/loss:

Cost Overrun = Actual Cost – Target Cost = 120,000 – 60,000 = 60,000

Buyer’s share of Cost overrun = Buyer’s ratio * cost overrun = 0.6 * 60,000 = 36,000

Seller’s share of Cost overrun = seller’s ratio * cost overrun = 0.4 * 60,000 = 24,000

Buyer’s price = Target Price + Buyer’s share (or) Ceiling Price, whichever is lower; 75,000 + 36,000 = 111,000 or Ceiling Price of 100,000, whichever is lower. 

Thus, the Buyer’s price = 100,000.

Seller’s Profit/Loss = Buyer’s price – Actual Costs = 100,000 – 120,000 = -20,000 USD.

Example – 2

Target Cost of Project = 60,000 USD; seller’s fee = 15,000 USD; ceiling price = 100,000 USD; ratio is 60:40; Actual Cost = 101,667 USD. Calculate the seller’s profit or loss.

Target Price = Target Cost + Seller’s Fee = 75,000 USD.

PTA = ((100,000-75,000)/0.6) + 60,000 = 41,667 + 60,000 = 101,667.

In this case, PTA is equal to the Actual Cost, which is above the ceiling price, but the buyer will pay only the ceiling price. 

As the Actual Cost is 101,667 USD, PTA is 101,667, and the ceiling price is 100,000, all costs above 100,000 will be borne by the seller (-1,667 USD).

A more detailed explanation of the seller’s profit/loss:

Cost Overrun = Actual Cost – Target Cost = 101,667 – 60,000 = 41,667

Buyer’s share of Cost overrun = Buyer’s ratio * cost overrun = 0.6 * 41,667 = 25,000

Seller’s share of Cost overrun = seller’s ratio * cost overrun = 0.4 * 41,667 = 16,667

Buyer’s price = Target Price + Buyer’s share (or) Ceiling Price, whichever is lower; 75,000+25,000 = 100,000 or Ceiling Price of 100,000, whichever is lower. 

Therefore, the Buyer’s price = 100,000.

Seller’s Profit/Loss = Buyer’s price – Actual Costs = 100,000 – 101,667 = -1,667 USD.

In the two examples above, when actual costs equal or exceed the point of total assumption, the buyer pays only the ceiling price, which the seller must pay out of pocket.

Example – 3

Target Cost of Project = 60,000 USD; seller’s fee = 15,000 USD; and ceiling price = 100,000 USD; ratio is 60:40; Actual Cost = 100,000 USD. Calculate the seller’s profit or loss.

Target Price = Target Cost + Seller’s Fee = 75,000 USD.

PTA = ((100,000-75,000)/0.6) + 60,000 = 41,667 + 60,000 = 101,677.

The Actual Cost is equal to the Ceiling Price. In this case, will the seller still be at a loss? Let’s dive in further to understand.

Cost Overrun = Actual Cost – Target Cost = 100,000 – 60,000 = 40,000

Buyer’s share of Cost overrun = Buyer’s ratio * cost overrun = 0.6 * 40,000 = 24,000

Seller’s share of Cost overrun = seller’s ratio * cost overrun = 0.4 * 40,000 = 16,000

Buyer’s price = Target Price + Buyer’s share (or) Ceiling Price, whichever is lower; 75,000 + 24,000 = 99,000 or 100,000, whichever is lower. So, the Buyer’s price = 99,000.

Seller’s Profit/Loss = Buyer’s price – Actual Costs = 99,000 – 100,000 = 1,000 USD.

Accordingly, sellers can be in the red (even before hitting the point of total assumption) when Actual Costs are equal to the Ceiling Price because of the sharing ratio.

In the three examples above, we can see that the seller didn’t get the fees and is at a loss.

So, when does the seller gets his fees in full as expected? This is set in motion when the actual cost is the same as the target cost, even if the seller cuts his profit margins or absorbs losses, as explained previously.

Let’s consider another example where the actual cost is the same as the target costs.

Example – 4

Target Cost of Project = 60,000 USD; seller’s fee = 15,000 USD; ceiling price = 100,000 USD; ratio is 60:40; Actual Cost = 60,000 USD. Calculate the seller’s profit or loss.

Target Price = Target Cost + Seller’s Fee = 75,000 USD

PTA = ((100,000-75,000)/0.6) + 60,000 = 41,667 + 60,000 = 101,677.

Cost Overrun = Actual Cost – Target Cost = 60,000 – 60,000 = 0

Buyer’s share of Cost overrun = Buyer’s ratio * cost overrun = 0.6 * 0 = 0

Seller’s share of Cost overrun = seller’s ratio * cost overrun = 0.4 * 0 = 0

Buyer’s price = Target Price + Buyer’s share (or) Ceiling Price, whichever is lower; 75,000 + 0 = 75,000 or 100,000, whichever is lower. So, the Buyer’s price = 75,000.

Seller’s Profit/Loss = Buyer’s price – Actual Costs = 75,000 – 60,000 = 15,000 USD.

In this case, sellers will get their full fees when the actual cost equals the target cost and the buyer will pay the target price as expected. 

We can see that with fixed-price contracts, sellers are motivated to monitor costs to avoid cost overruns or to lose money.

How To Handle Changes in Fixed Price Contract

The project environment is dynamic, and changes can happen regardless of clarity on the scope of work. In a fixed-priced contract, changes are costly and are priced higher than built-in rates because now the contractor is free to increase the price of new work. As a result, the seller has little flexibility here except to agree on the seller’s terms.

Keep the following points in your mind while dealing with changes in fixed price contracts:

  • Avoid changes if possible
  • Analyze the impact of change on schedule and cost
  • Provide the change with complete details
  • Have the proper authority sign it from the buyer and seller side
  • Don’t use contingency or management reserve to accommodate changes

When Should You Use the Fixed Price Contract

In the following cases, you can use the fixed price contract:

  • The scope of work is well defined and fixed.
  • You have completed a few similar projects in the past with similar scope of work.
  • The project uses the resources for which prices are fixed and known
  • When you can determine the project cost in advance with high confidence
  • There is no element of uncertainty in the project
fixed price contract table

Fixed-Price Vs Cost-Plus Contracts

Fixed price and cost plus are different contracts.

In a fixed-price contract, the scope of work is well-defined and fixed. The seller has to complete the task within an agreed duration.

In a cost-plus contract, the scope of work is not defined. The seller must complete the task as instructed by the buyer, and he will receive the cost he spent plus a fee as mentioned in the contract. The cost-plus contract has a flexible duration.

In a fixed-price contract, the risk is on the seller. In a cost-plus contract, the risk is on the buyer.

The seller spends less time reviewing the invoice in a fixed price contract, while in a cost plus contract, they meticulously check the invoice for any inflated costs as the seller gains a profit from the higher rates.

Advantages of Fixed-Price Contracts

  • This requires less work for the buyer to manage.
  • The seller has a strong incentive to control costs.
  • Companies usually have experience with this type of contract.
  • The buyer knows the total price before the work begins.

Disadvantages of Fixed-Price Contracts

  • If the seller underpriced the contract, they might try to overprice the change requests or lower the quality.
  • The buyer must invest resources to create a detailed scope of work.
  • This can be more expensive for the buyer than a cost-reimbursable contract as it includes risk contingencies. 

Conclusion

A fixed-price contract is useful when the scope of work is well defined, and both parties are experienced with similar work. The buyer is assured of a fixed price, and the seller is assured of fixed work. This contract is riskier for the seller and costly for the buyer.

You should choose a fixed-price contract if the scope is well defined, time is limited to monitor work, and there is a low chance of changes in the scope of work.

This concept is important from a PMP exam point of view. Understand it well if you are preparing for the PMP certification exam.

I hope this post on fixed-priced contracts has clarified this important concept. Please share your experience with this contract in the comments below.

Fahad Usmani, PMP

I am Mohammad Fahad Usmani, B.E. PMP, PMI-RMP. I have been blogging on project management topics since 2011. To date, thousands of professionals have passed the PMP exam using my resources.