Contract Types are basically two: Fixed-Price and Cost-Reimbursable. There is a third hybrid type called the Time & Materials contract
What is a Contract?
A contract is a mutually binding agreement that obligates the Seller to provide the specified products, services, or results; and obligates the Buyer to pay the Seller for the said products, services or results. It represents a legal relationship that is subject to remedy in the courts.
The major components in an agreement are:
- Procurement statement of work or major deliverables
- Schedule, milestones, or date by which a schedule is required
- Performance reporting
- Pricing and payment terms
- Inspection, quality, and acceptance criteria
- Warranty and future product support
- Incentives and penalties
- Insurance and performance bonds
- Subordinate subcontractor approvals
- General terms and conditions
- Change request handling
Termination clause and alternative dispute resolution mechanisms
Common Project Example
Different types of contracts coming up below would be best understood by considering a common project in all their examples, for example:
Project: A bridge of certain specifications
Estimated Project Cost: PRs 1.5 billion
Estimated Project Duration: 3 years
Customer: National Highway Authority (to be referred to as the Buyer in all examples
Project Contractor: Izhar Builders (to be referred to as the Seller in all examples)
Fixed Price (FP) Contracts
FP contracts set a Fixed Total Price for a defined product, service, or result to be provided. FP contracts are used when the Requirements are well defined and no significant Changes to the Scope are expected
Fixed Price Contract Types
Firm Fixed Price (FFP)
It is the most basic and commonly used contract. Aka the Lump Sum contract. The Fee (Contract Cost) is fixed. Entire Risk is on seller. Any cost increase due to bad performance of the Seller is the responsibility of the Seller, who is contractually bound to complete the job within the agreed amount
- FFP is mostly used in government or semi-government contracts where the scope of work is specified with every possible detail outlined.
- Any deviation from the original Scope can cost the Buyer heavily
Example: The Seller will complete and handover the bridge to NHA for PRs 2.1 billion in 3 years from the signing of the contract
Fixed Price Incentive Fee (FPIF)
In FPIF, although the price is fixed, the Seller is given an additional incentive based on his performance. However, should the Seller delay the project, he is likely to pay Liquidated Damages at the same rate
Example: The Buyer shall pay the Seller 1% of the contract cost for everyone complete month the bridge is completed and handed over earlier. The Seller shall pay the Buyer 1% of the contract cost as Liquidated Damages for every one complete month the bridge is completed and handed over late (early/late completion of the Project will help/constrain the Buyer start earning revenues from the bridge –tolls, for example -that much earlier/late)
Fixed Price with Economic Price Adjustments (FPEPA)
Used when a project is multi-year long. It protects the Seller against any adverse economic changes like inflation, cost changes in essential commodities, exchange rate (if the payments are in foreign currency), etc. by adjusting the project cost
Example: Two years after the project start date, the cost due to the Seller shall be increased by up to 3% based on the Consumer Price Index (CPI)
Cost Reimbursable Contracts
Aka Cost Plus (CP) contracts. In Cost Reimbursable Contracts, the Seller is reimbursed for completed work plus a fee representing his profit
- The Seller produces the original invoices to ascertain actual costs incurred
- Scope Creep is an inherent drawback of this contract, especially when the requirements are unclear
Cost Reimbursable Contract Types
Cost Plus Fixed Fee (CPFF)
The Seller is paid for all incurred Costs plus a Fixed Fee as his profit. The entire Risk is Buyer’s
- Fixed fee (% of initial estimated projected cost, or fixed amount) does not change after the contract is signed unless the Project Scope changes
- CPFF contract keeps the Seller safe from Risks
Example: The Seller shall be paid total cost incurred plus 12% of the initial project cost as fee
Cost Plus Fixed Fee (CPFF) Contract Example
In a procurement contract, the buyer and seller agree to a contract cost of PRs 100 million, payment of all expenses to the seller against verifiable invoices and 15% of contract cost as the seller’s fee.
What is a turn-key contract?
A turn-key contract is a contract in which seller/contractor perform all activities from beginning till end. (manufacturing from supply & maintenance). And yes, seller is responsible for all the possible risks in this type of contact.
Cost Plus Incentive Fee (CPIF)
The Seller is reimbursed for all costs plus an incentive fee based upon achieving certain performance objectives mentioned in the contract. The Risk lies with the Buyer; however, this Risk is lower than the CPFF contract
- Incentive Fee is calculated using an agreed on a predetermined formula.
- The incentive is a motivating factor for the Seller. If the Seller can complete the work with less cost or before time, he gets some incentive. Conversely, he shares the loss with the Buyer using the same formula. Most of the time, Incentive is a percentage of the savings/loss
Example: The Seller will be paid total cost incurred. If the project is completed under budget, 25% of the saving shall be given to the Seller. If the project is completed over budget, the Seller shall share 25% of the extra cost
Cost Plus Award Fee (CPAF)
The Seller is paid for all his legitimate costs plus some Award Fee which is based on Buyer’s satisfaction of certain broad subjective performance criteria that are defined and incorporated into the contract
- The evaluation of performance is a subjective matter, and Seller cannot appeal it
Example: The Seller will be paid total cost incurred. 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 PRs 10 million.
Cost Plus Percentage of Cost (CPPC)
The Seller is paid for all costs incurred plus a percentage of these costs. Like CPFF except that Fee is not fixed; it is tied to the Cost incurred. Preferred by Sellers; not by the Buyers. Rather, added Risk for Buyer that the Seller may artificially increase the cost to earn a higher fee
Example: The Seller will be paid total Costs incurred plus 12% of the Costs incurred as the Seller’s fee
Time & Materials (T&M) Contracts
Aka ‘Times & Means’ Contracts. This is a hybrid contract of Fixed-Price and Cost Reimbursable contracts. The Risk is distributed to both parties
- T&M contract is generally used when the deliverable is human Effort. In this type of contract, the project manager or the organization prescribes the required qualification or experience to the Seller who is responsible for providing the staff
- T&M contract is used to hire some experts or any outside support.
Example: The technician will be paid PRs 1,000 per hour