1. Brooks, Fredrick P., The Mythical Man-Month, Addison Wesley Longman, Inc., Reading, MA, 1995, p. 115.

2. Downing, Douglas and Clark, Jeffery, Statistics the Easy Way, Barron's, Hauppauge, NY, 1997, pp. 264–269.

3. Schuyler, John, Risk and Decision Analysis in Projects, Second Edition, Project Management Institute, Newtown Square, PA, 2001, pp. 35 and 52.

Chapter 9: Quantitative Methods in Project Contracts

Now this is not the end. It is not even the beginning of the end. It is perhaps the end of the beginning.

Sir Winston Churchill
London, 1942

Project Contracts

Contracts between suppliers and the project team are commonly employed to accomplish two objectives:

  • Change the risk profile of the project by transferring risk from the project team to the supplier. Presumably, a due diligence examination of the supplier's ability to perform confirms that the supplier has a higher probability of accomplishing the scope of work in acceptable time at reasonable cost than does the project team. The decision-making processes discussed in this book provide a method and tool for making contracting decisions.

  • Implement policy regarding sharing the project opportunity with participants in the supply chain. If the contract is related to a public sector project, public policy regarding small business and minority business participation may be operative on the project team. In the private sector, there may be policy to involve selected suppliers and customers in projects, or there may be policy to not involve selected participants in the project.

In this chapter, we will address project contracting as an instrument of risk management.

The Elements of a Contract

A contract is a mutual agreement, either oral or written, that obligates two or more parties to perform to a specific scope for a specified consideration, usually in a specified time frame. The operative idea here is mutual agreement. A contract cannot be imposed unilaterally on an unwilling supplier. In effect, as project manager you cannot declare the project to be in contract with a supplier, have an expectation of performance, and then return later and claim the supplier is in breach for not performing. Therefore, it is generally understood in the contracting community that the following five elements need to be in place before there is a legal and enforceable contract:

  • There must be a true offer to do business with a supplier by the project or contracting authority.

  • There must be a corresponding acceptance of the offer to do business by the supplier's contracting authority.

  • There must be a specified consideration for the work to be performed. Consideration does not need to be in dollar terms. Typical contract language begins: "In consideration of _______, the parties agree......"

  • The supplier must have the legal capacity to perform. That is, the supplier may not materially misrepresent the supplier's ability to perform.

  • The statement of work (SOW) must be for a legal activity. It is not proper to contract for illegal activity.

Project and Supplier Risks in Contracts

Contracts are used largely to change the risk profile of the project. Project managers contract for skills, staff, facilities, special tools and methods, and experience not available or not available at low enough risk in the project team itself. Some contracts begin as "team agreements" wherein two companies agree to work together in a prime contractor-subcontractor role, whereas other contracts are awarded to a sole source, selected source, or competitive source. [1]

Regardless of how the two parties come together with a contract, the fact is that both parties assume some of the risk of the endeavor. Contracting cannot eliminate project risk; project risk can simply be made manageable by transference to a lower risk supplier. For the project manager, the primary residual risk, once the contract is in place, is performance failure on the part of the supplier. The supplier may run into unforeseen technical problems, experience business failures elsewhere that affect the project, or be subject to external threats such as changes in regulations or uncontrollable acts of God. Of course, depending on the type of contract selected, the project manager may choose to retain some or most of the cost risk of the SOW and only transfer the risk of performance to the supplier.

The supplier is on the receiving end of the risk being transferred out of the project. If the supplier is competent and experienced, and has the staff, tools and methods, facilities, and financial backing to accept the SOW, then the supplier's risk is minimized and the contract is a viable business opportunity for the supplier. Further, as mentioned above, the project manager may elect to retain the cost risk and thereby transfer only performance risk to the supplier. But, of course, in all contracting arrangements, the project is the supplier's customer. Customers in a contracting relationship are a source of risk. The project (customer) could breach the contract — by failing to provide specified facilities, information, technical or functional assistance — or could fail to pay or could delay payments.

Both parties seek to minimize their risk when entering into a contract. The supplier will be inclined to identify risks early enough so that provisions in the contract can cover the risks: more money, more time, and assistance in various forms. The project team will be inclined to seek performance guarantees and the means to reward upside achievement or punish downside shortfalls. Each party invokes its risk management plan when approaching a contract opportunity.

Contracting Vehicles

Contracts used to convey the SOW from the project to the supplier fall into two broad categories:

  • Fixed price (FP) contracts that transfer both the cost and performance risk to the supplier. FP contracts require the contractor to "complete" the SOW. In this sense, FP contracts are "completion" contracts. FP contracts are appropriate when the scope of the SOW is sufficiently defined that a price and schedule can be definitely estimated and "fixed" for the required performance. FP contracts are inappropriate for many R&D activities where the scope of work is indefinite.

  • Cost plus (CP) or cost-reimbursable contracts that transfer only a portion of the cost risk to the contractor (supplier) and require only a contractor's "best effort" toward completing the SOW. CP contracts are not completion contracts. CP contracts are the appropriate vehicle for R&D and other endeavors where the scope is not defined to the point that definitive estimates can be made. Although CP contracts have an estimated scope of work, the contractor is only bound to perform in a reasonable and competent manner. The contractor is not bound to "complete" the SOW since the true scope is unknown. Projects with large "rolling wave" plans are best accomplished with CP contracts.

In addition to the FP and CP categories that broadly define which party has the cost and scope risk in the arrangement, there are categories for handling the amount of profit that a supplier can make on a contracted scope of work:

  • The profit (fee) could be built into the contract price and not visible to the project manager. Firm fixed price (FFP) contracts have only one dollar parameter: price. Only the supplier knows the potential profit in the deal; the profit is a combination of a risk premium to cover the supplier's assumed risk and a profit amount to earn the contractor's required return on cost.

  • The fee could be fixed by mutual negotiation (fixed fee, FF). FF is appropriately combined with cost-reimbursable contracts.

  • The fee could be variable depending on performance. Variable fees could be combined with either FP or CP contracts. Two fee types are typically employed: (1) an incentive fee that is paid according to a formula based on performance of either cost or schedule or both and (2) an award fee that is paid according to criteria of performance attributes. Award fee is not necessarily formula driven and the amount paid is always subject to the judgment and opinion of the award fee authority in the project.

[1]Sole source: there is only one contractor known to have the ability to perform the SOW. Selected source: a contractor selected without competition to perform the SOW. Competitive source: a contractor selected from among a peer group of competent offerors on the basis of competition.