Contracts are an integral aspect of the procurement process that, when negotiated successfully, can help organizations mitigate certain projects risks and establish competitive advantage. As defined by the PMBOK (Project Management Institute, 2017) contracts fall into the following categories and sub-categories:
Fixed Price Contracts- used when project requirements are well established with no expectations for changes to a project’s scope to occur. A defined price is set for the delivery of a product, service, or result.
Firm Fixed Price (FFP)- the price of goods/service/result rendered is fixed and will not change unless the scope of the overall deliverable changes. These contracts are favored by buyers since the seller shoulders the cost burden resulting from deviations of agreed upon terms. FFP contracts are suitable to transactions that involve highly repeatable functions that the seller has extensive expertise and experience with. One example is the purchase of standard model cars from a manufacturer. The manufacturer has a very detailed idea of the costs involved in producing a car and can guarantee that cost with limited risk of exceeding those costs.
Fixed Price Inventive Fee (FPIF)- similar to FFP contract in that a fixed price is offered for the delivery of a good/service/result with the addition of predetermined incentives built into the contract that will be realized if certain performance metrics are achieved. Sticking with the car manufacturing example, incentives may be offered to the seller if the ordered cars are delivered early.
Fixed Price with Economic Price Adjustments (FPEPA)- a fixed price contract that contains predetermined adjustment calculations. These types of contacts are utilized when there will be considerable time requirements for the seller to delivery the agreed upon good/service/result or in instances where different currencies will be used. These adjustments help to ensure that both the buyer and seller get a fair market price for the contracted arrangement. In individual instances, depending on commodity price changes, local inflation changes, either the buyer or seller could receive a better deal than originally agreed upon. Lets say that a US manufacturing firm has a supplier that does not operate in US dollars. Contractual amendments may be built in that allows for a reassessment of cost if changes in currency exchange rates exceeds a certain threshold.
Cost-Reimburse Contracts- a reimbursement of the seller by the buyer of any legitimate costs incurred during the completion of a contract in addition to an agreed upon fee that allows the seller to turn a profit on the endeavor. These contracts should be used if the scope of the project is expected to be dynamic and allows the seller to pass some of the risk of rising input prices on to the buyer.
Cost Plus Fixed Fee (CPFF)- seller is reimbursed for costs incurred as well as a fixed-fee payment that is calculated as a percentage of the initially agreed upon estimates for overall project cost. Unless the project scope is changed, these fees remain constant. An example of a CPFF contract compatible project would be the design on an app. Even though many apps have been developed, individual challenges encountered throughout each instance causes deviations to occur while fulfilling project delivery.
Cost Plus Incentive Fee (CPIF)- seller is reimbursed for costs incurred and receives a pre-agreed upon incentive fee for meeting performance objectives. The buyer of an app may offer the seller incentives for completing delivery ahead of schedule. This type of contract allows risks to be shared by both the buyer and seller but it encourages quality work to be completed in a timely manner.
Cost Plus Award Fee (CPAF)- similar to a CPIF contract but the award fee received by the seller is determined at the sole discretion of the buyer based on the meeting of prearranged performance criteria by the seller. In a CPAF contract, the buyer would set checkpoints throughout a project to monitor quality, milestone completion, etc… in order to determine the seller’s performance and decide on whether or not an award fee is merited.
Time and Material Contracts (T&M)- a hybrid contract that contains aspects of both fixed price and cost reimbursable contracts that are used when the scope of the project is not easily determined at the outset. These T&M contracts may require the reimbursement of legitimate costs up to a predetermined ceiling. A company that is contracting the development of a new product could agree to reimburse all costs up to $1,000,000. Any associated costs beyond this threshold would be the responsibility of the seller.
Something that I came across that I found to be interesting was the relationship between firm size and their responsiveness to changing prices. Kosmopoulou, Lamarche, and Zhou (2016) found that by instituting policies that incorporated price adjustment clauses to insulate governmental agencies from volatile commodity pricing fluctuations, there was an increase in the number of small firms that provided bids for road construction projects. This increase in the number of firms participating in the bidding process is due to the smaller firms being more nimble and able to adapt their prices to changing market conditions whereas larger firms tend to be slower moving in adapting to changing market conditions. Additionally, the more firms that are involved in the bidding process helps to ensure that the buyer is getting the best possible price for services rendered.