Contracts, oh contracts. Are you asking yourself, “Aren’t those someone else’s responsibility?”
As a PMP you will be expected to have knowledge of different contract types and what contracts should be used when. Remember PMPs are expected to maintain relationships with ALL stakeholders, and a vendor (or seller) is a VERY important stakeholder.
You will likely have support from a Procurement Office within your organization, but if not, you need to understand that contracts are your responsibility as a PMP. As you Plan Procurement Management (hopefully you caught the reference to the PMP Process Chart) you, with the support of your project team, will decide what contract type you should use for your project.
In this post let’s discuss the types of contracts you should know for the PMP exam and an example of when to use them.
PMP Contract Types
We will break our discussion of the seven contract types into three larger groups of contracts – fixed-price, cost-reimbursable, and time and material.
A Fixed-Price contract is a contract that has a predetermined-set price for a specific product or service. This means that if the vendor completes the product or service as defined in the contract, they will receive the agreed to price.
Scope for the service or product cannot change without a price change; however, fixed-price contracts can build in some flexibility for payment such as incentives or adjustments based on environmental factors.
Fixed-Price contracts are good to use for products or services that a seller creates repeatedly. A fixed-price contract should only be used when the seller is confident in the process it takes to complete a product or service, because fixed-price contracts put the most risk on the seller.
Firm Fixed Price (FFP)
A FFP is the most common type of fixed-price contract. In an FFP contract that scope of the product or service should be exact. The price will be set on the buyer’s request.
A FFP should be used for a product or service that is a repeated process. As an example, a car manufacturer would enter into a FFP contract for a standard model car. The manufacturer knows what it takes to complete the car and the associated cost. The manufacturer is confident that they will be able to deliver on the predetermined firm-fixed price.
Fixed Price Incentive Fee (FPIF)
A FPIF is similar to the FFP; however, a FPIF also offers an incentive if the product or service exceeds an expectation. For example, a buyer might give the seller an incentive fee if the seller completes the product early.
Using the example above of our car manufacturer, a buyer might provide an incentive when the manufacturer delivers the car early. This early delivery allows the buyer an additional week of use, which puts the entire project ahead of schedule. Thus, the buyer wants to show appreciation with an incentive.
Fixed Price with Economic Price Adjustment (FP-EPA)
A FP-EPA is like a FFP, with one exception, if the product or service is largely reliant on an input with a price that is governed by supply and demand, a seller could increase the price of the overall contract accordingly.
Okay, what does that mean? Let’s use our car example again, but add a different piece to the discussion, if the buyer wanted a standard model car with a supply of gas for one year, the seller could adjust the overall price of the contract based on the cost of petroleum.
Since the seller has no control over how much gas will cost when the car is ready for delivery, the overall contract cost might increase if the gas price increases. However, the only portion of the contract that would increase is the portion tied to petroleum costs.
Cost-reimbursement contracts are different from fixed-price contracts as the buyer takes on more risk. In all the cost-reimbursement contracts the seller can charge for all legitimate expenses related to completing the product or service, as well as charge a fixed fee as profit for their work.
In a cost-reimbursement contract the seller has more flexibility to complete the scope of work. However, the buyer runs risk if the scope costs more than anticipated.
You would use a cost-reimbursement contract when the seller is not confident in the process it takes to complete a product or service. For example, completing the code for a new app. Although many apps have been created before, there is not an absolute template on how long the it takes to create the correct code.
Cost Plus Fixed Fee (CPFF)
In a CPFF the seller can charge the buyer for all legitimate expenses related to completing the product or service. However, the seller can also charge a fixed-fee that is a percentage of the overall contract price. Remember this fixed-fee is set at the beginning of the contract, and even if legitimate expenses increase this fixed-fee remains the same.
Using our example above, you could use this type of contract to secure a seller to build an app. The seller would provide all legitimate cost, like expense for a coder’s time, in the initial estimate. Based on this initial estimate the seller would include a fixed-fee that is a percentage of the legitimate costs they calculated. At the end of this contract, as the buyer, you would be responsible for all legitimate costs incurred and the fixed-fee.
Cost Plus Incentive Fee (CPIF)
In a CPIF both the seller and the buyer assume risk. Let me explain. In A CPIF contract the buyer is responsible for legitimate costs of the project work, but if the seller does not accurately project estimates, the seller and the buyer split the responsibility of costs that are greater or less than the estimate.
Additionally, if the seller completes the work in a manner that exceeds an expectation write in the contract, the buyer will provide an incentive fee.
If we use our example of creating an app again, we would use the CPIF contract type if this was the first time ever that an app of it’s kind was developed. Since there are no benchmarks there are risks on both the side of the seller and the buyer. However, if the seller completes the app a month ahead of schedule the buyer will want to reward the effort.
As I noted the CPIF puts risk on both sides, but it also provide motivation for the seller to complete quality work that exceeds expectations.
Cost Plus Award Fee (CPAF)
A CPAF is very similar to the CPIF we just discussed. However, the main difference here is the award fee is at the sole discretion of the buyer. The buyer would set predetermined expectations for the seller in the contract. If the seller meets those items, to the satisfaction of the buyer, than an award is provided.
Let’s use our app example again. If you entered into this agreement with a CPAF contract, as the buyer, you would set checkpoints within the project work to check on quality, percent complete, etc. to determine if award fees were worthwhile. It is important to remember that these award fees are solely at your discretion as the buyer.
Time and Material Contracts (T&M)
Last but certainly not least are time and material contracts. T&M contracts are a cross between fixed-price and cost-reimbursable. They are a cross because they can take on either form. T&M are typically used when the scope of work cannot be well defined when the contract is created.
T&M can be more like cost-reimbursable when the buyer agrees to pay for all legitimate expenses.
However, T&M can be more like fixed-price when the buyer sets firm parameters on expenses upfront. For example, this product or service can not cost more than 100,000 to complete.
A T&M is likely the easiest to remember as the buyer will pay the seller for all time and material it takes to complete the product or service, within reason.
Let’s go all the way back to our car example. As a buyer let’s say you want a seller to make a new kind of energy efficient car, unlike any other on the market. You cannot easily define scope as you are not sure what type of energy will be used, etc. As the buyer you could enter into a T&M contract that states you will pay for all time and material up to 5 million dollars. If the project exceeds the limit it will not be reimbursed, unless a new agreement is made.
PMP Contracts: Final Thoughts
There will be a fair amount of contract questions on the exam. It is good to understand what these contract types are (and even memorize the acronyms).
For example, you will see questions like this:
1. In which contract type is the seller most concerned about creating an accurate budget based on a detailed scope of work?
a. Cost-plus award
b. Fixed-price incentive fee
c. Firm-Fixed price
d. Time and materials
Did you get it right, C. Firm-fixed price? If not go back through this post and review. Remember in firm fixed-priced contracts the seller is assuming a lot of the risk!
For questions like this you need to be able to compare and contrast the types of contracts.
Finally, contracts are a part of the procurement management knowledge area, and are typically developed within the planning phase of the project. Be sure you take some time and understand how contracts relate to the overall PMP Processes, because remember it is very important that you know how all this information works together.
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