fixed price contract

A fixed-price contract is the most commonly 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 ultimate cost is firm.

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

Let’s get started.

Fixed-Price Contract

You use a fixed-price contract when the scope of work is well defined. This type of contract can be used for acquiring 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 one with the lowest offer, 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 has to bear the brunt under this agreement. 

As there are no additional surprise costs involved, buyers don’t have to worry about auditing invoices. The seller carefully focuses on 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 crop up that will affect the quality of the work. An inexact scope can also cause cost overruns and delays. 

Also, any additional work usually costs more than the normal price of planned work; surprises are never cheap. 

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

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 exactly what the cost will be.

How Does a Fixed-Price Contract Work?

  • Fixed-price contracts are used when the requirements are well defined. 
  • As the scope is clearly defined, the seller can promise a set price. 
  • 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 any changes, additional work, or any 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, set price.

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 stipulates that 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 the 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 similar to Fixed-Price Incentive Fee (FPIF) contract, except in FPIF, the criteria are objective and outlined in the terms and conditions, whereas 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 is a flexible type of contract that shares some of the 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, and 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 buyer and seller are somewhat unhappy since they both are making less money but at a gradual, 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 type of contract is normally unilateral (signed by one party instead of both parties). However, some buyers require sellers’ signatures on a purchase order before considering it official. 

This is normally used for commodity procurements, becoming firm contracts 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.

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 is used to compare 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 on 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, 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 Actual Costs, which is above the ceiling price, but the buyer will pay only the ceiling price. As the Actual Cost is 101,667 USD and 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 on 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, 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, 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 full fees as expected? This is possible when the actual cost is the same as the target cost, beyond which either seller cuts his profit margins or absorbs losses, as explained above.

Let’s consider another example where the actual cost is the same as 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, 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 as expected when the actual cost equals the target cost, and the buyer will pay the target price as expected. 

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

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 has to 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, and you don’t have a lot of time to monitor work, and you have fewer chances of change controls.

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.