Contract Types


Contract types are tools in planning purchases and acquisitions that are important for the examination as well as for professional management. There will be several questions on the exam about the different types. One of the important facts to know is the degree of risk for the seller and the buyer that each type of contract contains. This graphic shows the risk levels for each of these types of contract.

Figure 16-1. Risk levels for contract types.


Each of the contract types has risk attached to it. As we go through these contract types, you need to learn who assumes the most risk, the buyer or the seller.

Fixed price/lump-sum contracts In this type of contract, the seller assumes the greatest risk because the price is set. This means that the seller must comply with the contract and provide the service/product for a specific price. If the time it takes to deliver the service/product expands, the seller cannot charge for the extra time. The same would be true if extra materials were needed to deliver the service/product. If this occurs, the seller cannot charge for the extra materials because the price for the contract is already fixed.

Incentives can be used with a fixed price contract based on meeting project deliverables or exceeding them. These deliverables could include schedules and costs as two of the measurements for incentives. In addition, some economic adjustment such as cost-of-living increases could be written into a fixed price contract.

Cost-reimbursable contracts These contracts involve paying for the actual costs that the seller incurs plus an agreed upon fee that will represent the profit for the seller. For the most part, the buyer is buying direct costs, costs that are incurred because the project is being done. Indirect costs are often called either overhead or general and administrative costs. These are costs that occur no matter whether the project is progressing or not, and a short negotiation may be necessary to have indirect costs included in the total cost package. There are several types of cost-reimbursable contracts to consider.

The cost-reimbursable contract has risk for both sides. If the contract is well written and specifies what costs can be included and those that are excluded, then the buyer is protected. If the allowable costs are not well defined, the buyer takes the risk of having the seller incur costs that are not expected. The key, as with all contracts, is clarity regarding what costs are allowable.

Cost-Plus-Fee (CPF) or Cost-Plus-Percentage of Cost (CPPC) When the contract is cost-plus-percentage of cost, the seller is reimbursed for costs that are incurred for performing the contract work, and then the seller receives a percentage of the cost that is agreed upon before beginning work. In this case, the fee varies with the actual cost.

Note that in this type of contract, you have a variable cost contract and you need to manage the costs as the seller incurs them. It is necessary in any type of cost-reimbursable contract to determine the costs that will be allowed and have these written in the contract. This type of contract puts most of the risk on the buyer.

Cost-Plus-Fixed-Fee (CPFF) In this type of contract, the seller is reimbursed for allowable costs and then receives a fee that is agreed upon before beginning the work. The fee will be the profit for the seller, so the seller should try to maximize the fee while the buyer tries to lower it. With good-faith negotiating, it is expected that both sides will come to an agreement on the fee quickly. The main part of writing this type of contract, as it is with all cost plus contracts, is to make sure that allowable costs are specified in the contract. Rather than having to go to formal arbitration or some other form of arbitration, it is most effective to have agreement by both parties to the contract as to what is allowable.

Cost-Plus-Incentive-Fee (CPIF) The seller is reimbursed for costs as with all cost plus contracts. In the case of the incentive fee, it is a predetermined fee that is paid if certain conditions of the contract are met or bettered. There will also be cases where both parties, buyer and seller, will benefit from producing above expectations.

Time and Material contracts (T&M) These types of contracts are a cross between cost-reimbursable and fixed price contracts. These contracts contain the highest risk for the buyer because they are open-ended. The seller simply charges for what is done to produce the product/service in the contract. This can be a problem if the time scheduled for the production is greatly underestimated. Because the contract simply states that time and materials will be paid for, the seller can charge for time that is needed, no matter whether it exceeds estimates. In the cases where time or material greatly exceeds the estimates, there may be a need for arbitration to determine the correct fee. The fixed price component of a T&M contract comes with agreement between the seller and buyer as to the types of materials that can be used and the amount of time that is expected. For instance, the buyer may require that standard versions of products be used in the building of a house rather than custom-made products.

The greatest risk to the buyer is the T&M contract. The greatest risk to the seller is the firm fixed price contract. Often, buyer and seller will negotiate aspects of both types so that the risk is spread between both the seller and the buyer.

Q.

There are three general types of contracts: cost reimbursable, time and materials, and ________.

 

A.

Cost required

 

B.

Fixed price

 

C.

Simple cost

 

D.

Reimbursed time


The answer is B. The third type of contract is the fixed price, often called the firm fixed price contract.

Q.

Which type of contract has the highest risk for the buyer?

 

A.

Fixed price

 

B.

Reimbursed time

 

C.

Time and materials

 

D.

Cost plus


The answer is C. There may be major variations between the estimated amount of time and the actual amount of time spent. In a time and materials contract, the buyer agrees to pay for time used by the seller, which creates the risk.

Q.

In the cost plus contract with the initials CPFF, the FF stands for ________.

 

A.

Formula foundation

 

B.

Free fixed

 

C.

Founded fixed

 

D.

Fixed fee


The answer is D.

Q.

Which type of contract has the highest risk for the seller?

 

A.

Fixed price

 

B.

Reimbursed time

 

C.

Time and materials

 

D.

Cost plus


The answer is A. Because the price is fixed in the contract, the seller must absorb any costs that are not covered in the initial contract.

Q.

The type of contract where the buyer and seller share in the savings is ________.

 

A.

Fixed Price

 

B.

Cost reimbursable with incentive fee

 

C.

Cost reimbursable with fixed fee

 

D.

Time and materials


The answer is B. The percentage of the savings that will go to the seller and buyer is negotiated at the time of writing the contract.

Q.

Which type of contract uses a percentage of cost as a part of the agreed upon contract?

 

A.

T&M

 

B.

CPFF

 

C.

CPIF

 

D.

CPPC


The answer is D. The acronym reads "cost plus percentage of cost."

Here is an example of a question that uses the cost plus incentive fee contract.

Q.

A buyer negotiates a fixed-price incentive contract with the seller. The target cost is $200,000, the target profit is $35,000, and the target price is $250,000. The buyer negotiates a ceiling price of $280,000 and a share ratio of 70/30. If the contract is completed with actual costs of $180,000, how much profit will the buyer pay the seller?

 

A.

$49,000

 

B.

$41,000

 

C.

$38,000

 

D.

$29,000


The answer is B. This is how to work this problem out. The numbers that you need to be concerned with are the target cost, $200,000, the target profit, $35,000, the share ratio of 70/30, and the actual costs of $180,000. (In a share ratio, the first percentage goes to the buyer and the second number is the percentage that the seller will get.) Using these numbers, the calculation goes like this. You subtract the actual costs from the target cost, which gives you $20,000. Seventy percent of that goes to the buyer, whereas thirty percent goes to the seller. In this case, that would be 30% of $20,000 or $6,000. Add $6,000 to the target profit of $35,000, and you have your answer, which is $41,000.

The outputs of planning purchases and acquisitions are the procurement management plan, the contract statement of work, make-or-buy decisions, and requested changes. The procurement management plan can be simple or very complex depending on the type and size of the project. Some of the parts of a procurement management plan are:

  • Definition of the contract types to be used

  • What actions the project team can take by itself if the organization already has a purchasing, legal, or procurement department

  • Document types to be used

  • Constraints and assumptions

  • How to estimate and handle lead times for procurement

  • Mitigation of project risk through insurance or performance bonds

  • Identifying pre-qualified sellers

  • Metrics used to manage contracts and evaluate seller offers

(There are other parts of the procurement management plan in the PMBOK. These can be found on page 279 of the 3rd edition.)

The contract statement of work describes the various procurement items in sufficient detail to give prospective sellers a guideline to see whether they can provide the item or items. This contract statement of work (CSOW) is a subset of the SOW. A CSOW may include specifications, quantities, quality levels, requested performance measurements and data, the work location, and the amount of time expected to fulfill the contract.

Q.

Definition of contract types to be used, how to handle lead times for procurement, and metrics used to manage contracts are all found in the ________.

 

A.

SOW

 

B.

Procurement management plan

 

C.

WBS

 

D.

Scope Statement


The answer is B.

Q.

The document that gives detail to prospective sellers concerning item or items to be purchased is the ________.

 

A.

SOW

 

B.

Charter

 

C.

WBS

 

D.

CSOW


The answer is D. The contract statement of work is the place where detail is given, not the SOW. The CSOW is considered a subset of the SOW.

The make-or-buy decisions, which have been made by going through the make-or-buy analysis, will also be listed as an output of the planning for purchasing and acquisition. The main point is that the decisions (and why they were made) have been documented so that they can be examined if necessary.

The final output is the requested changes that have been made to the overall project management plan because of the planning of purchases and acquisition.



Passing the PMP Exam. How to Take It and Pass It
Passing the PMP Exam: How to Take It and Pass It: How to Take It and Pass It
ISBN: 0131860070
EAN: 2147483647
Year: 2003
Pages: 167
Authors: Rudd McGary

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