Plan Procurement – Contract Types

April 11, 2010
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Introduction

A contract defines the exact way a procurement action will be carried out by defining the responsibilities of the seller as well as the buyer. There are two major types of these legally binding agreements. The first and the most used type are the fixed type contracts. The seller is bound by the terms of such contracts to supply the products, service or result at a price determined at the beginning of the contract and agreed to by the seller.

The second major type is the cost reimbursable type of a contract. These contracts stipulate that all legitimates costs related to creating the product, delivering the service or other items of the procurement action will be reimbursed. There is a fixed fee added to that to cover reasonable profits of the seller and incentives, if applicable.

Sometimes a third hybrid type of contact is used that contain elements of both the fixed price type and the cost reimbursable types. These are the so called time & material contracts.

Each of these types may have some variations. Using a specific type or a sub-type is all about sharing of risks involved in delivering the acceptable deliverable at the end of the procurement action. While the fixed price contracts is for the seller to cover all the risks, the cost reimbursable types are fit for situations where both buyer and seller agree to share the risks. As any changes in producing the product or the services or whatever due to risk are shared by the buyer and the seller. The buyer covers all such reasonable costs. Some of the sub types even have an incentive payment if the goal is met.

There are Contracts & Contracts

The fixed price contracts are the most preferred type and required in most procurement actions. As most risks are covered by the seller, it is natural for the seller to add to actual costs that cover his risks. Thus there is always a likelihood of somewhat higher cost of total ownership. The type of contract to be used will actually depend on the type of project being executed. However, when you need to deviate from the norm, the project team will have to justify that. They will need to pitch in too to specify the terms & conditions unique to your needs.

Fixed Price Contracts are executed at an all-inclusive price as agreed before the signing of the contract. However there are variations possible that allows for payment of an incentive as extra if the work is done successfully and at or beyond some defined targets. These may be schedule, cost or some defined performance criteria. While the seller faces financial damages if not done within the parameters of the contract it is obligated on the buyer to define the requirements clearly. Changes may be accommodated they would cause additional prices to the seller usually. There are sever4al types of these fixed price contracts that can be used.

Foremost among these are the FFP or the firm fixed price type of contracts. As the name implies the price is firm and fixed. The seller is obligated to complete the effort, whether his costs increase in doing so. The losses due to schedule slippage also are to his account. He cannot charge the buyer, unless there is a change in the requirements. A variation on the theme is the FPIP or the fixed price with incentive fee contract that allow an incentive payment at the end of the contract. These allow some flexibility in performance. The incentive amount can be defined to be related to some targets. These, usually, are cost, schedule and performance related. There is a ceiling set and any costs incurred by the seller beyond this ceiling price are borne by the seller. FP-EPA or the fixed price with economic price adjustment contracts usually allow for the changes in prices/costs related to the inputs used by the seller in delivering the procurement item. These, typically would be long-term contracts and would be tied to some acceptable price rise index for a final adjustment of the project cost at the end of it.

The second major type of contracts is the cost reimbursable type and it too has three variations. The first of these is the CPFF, CPIF and the CPAF types. The first of these the CPFF or the cost plus fixed fee type allows for all legitimate costs involved in delivering the product or service. There is a fixed mutually agreed fee that allows for a reasonable profit for the seller. This usually is a percentage of the total cost of the project. This fee amount does not change if the seller performs better than expected. It remains the same unless there is a scope change. The CPIF allows for a pre determined and agreed incentive fee on good performance on some performance indices. Depending on the seller performance the costs may be over/under the targeted costs. Such contracts will usually provide some formula for sharing these savings and overages. CPAF types allow for a award fee paid at the end of the contract. In these types cost are reimbursed alright. But a large part of the fees is a award decided by the buyer. This typically would be decided by an award fee board constituted from members of the buyer organization. The extent of award is not appealable.

The hybrid type of T&M or the time and material contracts tries to balance the fixed price and cost reimbursable types. Usually the project costs as paid to seller depends on his using resources at some fixed, predetermined rates. These rates then are used to calculate costs depending on the time duration each of these resources are used. Because of the open ended nature of the terms, most organizations would impose a not to exceed amount for a given procurement action.

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One Response to Plan Procurement – Contract Types

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