Procurement Management Contract Types

Submitted by victor.sequeira on Fri, 09/10/2010 - 02:34

I keep on reading articles on Procument management contract types and get confused all the time. Questions
that confuse me include :
a) Which contract type is more riskier to the buyer/seller (this applies not only between Fixed Price Contracts VS T&M contracts VS Cost Reimb. contracts but also within a specific contract type i.e. CPFF VS CPIF VS CPPC VS CPAF contract)
b) Which contract type would be used in which situation .

For example even the PMBOK mentions that when the scope of the project is not well defined to use the Time and Materials contract and says the same thing for the cost reimbursable contracts. So if we have both the choices as our answers which one do we choose?

I would appreciate if someone gives a detailed explanation for this.

Thanks.

Forums:

PMP / CAPM exam Question bank

pmpodcast

Sun, 09/19/2010 - 18:51

Permalink

Contract Types and Risk

Hi,

Although I have answered the same question at some other forum, I would like to repeat my answer over here so that others may benefit from it as well:

Risk is “uncertainty”, can be good or can be bad. The traditional concept of risk is that it is always negative, and that is perhaps confusing you on such questions. First of all, whenever you see the word “risk” in any PMP question, substitute it with “uncertainty” to eliminate the confusion created by the traditional definition. Now regarding the questions addressing the risk shared by buyer and the seller by the means of a contract type, we have to determine who is more “uncertain” regarding the procurement arrangement.

First let’s address the basic categories and then I will go into the sub-categories. The three basic contract types are; Fixed Price Contracts, Cost Reimbursable Contracts, and the Time and Materials Contract.

Fixed Price Contract:

===============

Remember that every contract has two most important driving factors, i.e., the price and the scope of work. Also the price hits the buyer, whereas the scope of work hits the seller. Since the price is fixed in the fixed price contract, the “uncertainty” is not with the price, so the buyer doesn’t have any “uncertainty” on its part. If the scope of work was not studied in a greater detail earlier, and during any point in time more work or effort is required to complete the contracted work, this would hit the seller and the “uncertainty” lies with the seller. Hence fixed price contracts are more risky for the sellers.

Cost Reimbursable Contract:

====================

In cost reimbursable arrangement, all the price of work complete is invoiced to the buyer. The total cost of the arrangement is always “uncertain” to the buyer till the job is complete. On the other hand, the seller is “certain” that all the costs will be born by the buyer even if the scope of work was not negotiated earlier, so there is no “uncertainty” on the seller’s part. Hence the cost reimbursable contracts are more risky for the buyers.

Time and Materials Contract:

====================

Time and Material are a hybrid type of contractual arrangement that contain the aspects of both cost-reimbursable and fixed-price contracts, so the risk is balanced between the buyer and the seller.

Now lets look are the sub-categories.

Firm Fixed Price Contracts (FFP):

========================

In Firm Fixed Price Contracts, the margin(fee) is fixed. Any change in effort or work will directly hit the seller. The seller’s risk is at maximum over here.

Fixed Price Incentive Fee Contracts (FPIF):

==============================

Although the price is fixed, the seller’s margin is a bit variable. The seller will be rewarded by a higher margin based on the performance. Still since the price is fixed, the seller is at risk (it’s a fixed price contract after all) but in comparison with the firm fixed price contracts, the risk is lower for the seller.

Cost Plus Fixed Fee Contracts (CPFF):

===========================

The risk for the buyer is maximum over here since all the costs will be reimbursed plus a “fixed” fee will be paid to the seller regardless of the performance.

Cost Plus Incentive Fee Contracts (CPIF):

=============================

Although all the costs will be reimbursed to the seller, the seller’s fee (or margin) will be determined by the performance. This places a slight control over the arrangement. Again, since it’s a cost reimbursable contract, the risk lies with the buyer, but in comparison with the CPFF contract, the buyer’s risk is lower.

Note: Please note that “incentive” in the fixed price arrangement, reduces the risk of the seller. While the “incentive” in the cost reimbursable contract, reduces the risk of the buyer. Don’t associate the risk of either the buyer or the seller to the work “incentive”. Rather associate the word “incentive” with “reduced”. If the incentive is with the fixed price contract, the risk is “reduced” for the seller. If the incentive is with the cost reimbursable contract, the risk is “reduced” for the buyer.

Remember this thumb-rule:

Fixed price – Seller’s risk

Cost reimbursable – Buyer’s risk

No incentive/fixed fee – Pure risk

Incentive – Reduced risk

Let’s combine all of this information into a list of contract types ordered by the reducing level of risk for the seller:

1. Firm Fixed Price Contract (Seller’s maximum risk)

2. Fixed Price Incentive Fee Contract

3. Time and Materials Contract

4. Cost Plus Incentive Fee Contract

5. Cost Plus Fixed Fee Contract (Buyer’s maximum risk)

I hope my “essay” would have resolved the confusions, and my “words substitution” technique hasn’t confused you further. In anything concerns you, feel free to reach out to me.

Regards,

Exam Support Team

The PM PrepCast - http://www.premiumcast.com/vp/50398/16780/10399/

szncor

Wed, 04/18/2012 - 16:54

Permalink