In the last lesson, we discussed how to prepare a procurement management plan. We also discussed the three types of common contracts. Fixed price, cost reimbursable, time and material. In this lesson, we'll discuss these contract types, and when to use them. The first contract type is Fixed Price Contracts. With this type of contract, the cost of procurement is fixed at the time of the agreement. A Fixed Price contract requires a well-defined scope statement and schedule so that the requirements are well-defined. There are three types of fixed priced contracts. The first is firm fixed price contracts. In these agreements, the price is fixed at the beginning of the contract and no changes are allowed without a formal change order. These contracts are best used when the scoped can be very well defined. And all the requirements are set out in day one. The next type is fixed price incentive fee contracts. These agreements are very similar to the fixed priced contracts with one major change. They contain a bonus penalty clause where an additional fee can be earned or a penalty incurred based on a set of very specific criteria. For instance, we may allow additional fee if the item was delivered early or penalize the supplier if the items don't meet certain performance criteria. All of these conditions must be specified at contract award and they should align with the overall project's strategic objectives. And finally, we have fixed price with economic price adjustments contracts. This is a fixed priced contract with an adjustment mechanism for specified changes in the market conditions. These are appropriate when market conditions can change rapidly. For instance, when copper prices are increasing every week, a contract with this mechanism might be indexed to copper prices so that it automatically adjusts with the price of copper. They're typically used when the risk of changes to a commodity price is so great that no one will supply the requirements without an adjustment. The adjustments are always based on public schedule that all can reference. The key thing to remember about a Fixed Price Contract is that it sets the minimum price you will pay for the goods, services or results. Change orders may increase the price, but rarely do they result in a reduction. The next general contract type is Cost-Reimbursable Contracts. With this type of contract, the seller is paid for all allowable costs plus a fee or markup. These contracts are typically used when the scope is reasonably well known. But cannot complete the contract award. We know it will evolve and change over time. For instance, if we ask someone to construct a custom house, we want them to follow the plan. But we also want to pick our finishes and fixtures as we go. We do not know the total scope at the onset. So we will pay the actual cost of any supplies, plus a fee for his time. This is a Cost-Reimbursable Agreement. Again, there are three common types of reimbursable contracts. The first is cost plus Fixed Fee contract. In this approach, the seller is reimbursed for all allowable costs. Plus, they receive a fee that is fixed based on the baseline cost estimate. In this case, once the fee is fixed, it can only be changed by a change order to the project. This incentivizes the seller to reduce the amount of resources they use so that the fee per resource employed is maximized. The next type is cost plus incentive fee contract. This approach is similar to the fixed fee approach, except in this case, the fee is based on achieving certain project goals that are set out in advance. Similar to the fixed price with an incentive fee case. Again, the key is to make the incentive goals align with the strategic goals of the project and the organization. So the seller is supporting the project as he goes. The last reimbursable type is cost plus award fee contract. In this case, the fee is based on a set of subjective criteria determined by the buyer. The criteria is set out in advance, but the grading of how well the seller does to get them is subjective and by the buyer. The criteria may include things like teamwork, cooperation, quality, efficiency or any other item that's important to the project. The last contract type is the Time and Material Contract. This type of contract is typically used when the scope of the contract is not well known and we know it will change over time. It allows for the scope to be developed as we go and still allows the supplier to recover their costs. This family of contracts are Hybrid Contracts that use elements of the Fixed Fee approach and the Cost-Reimbursable approach. In one case, the seller might get reimbursed all allowed costs plus a sliding scale fee that is a markup to the billed cost. Another case, maybe a fixed unit rate per unit employed. The unit may be manhours or it may be material installed or supplied. In this case, the fee is included in the unit rate but the number of unit is variable. So how do we decide which contract type to use? The first thing we should consider is what are the standards for our industry? What types of contracts does our organization usually use? Many time, the contract type is dictated by one of these answers or both. Next, we should consider the amount of project definition available. The better the definition surrounding the procurement activity, the more we can use a fixed price with minimum risk. If the projects lack definition, then time and material approach may be the best. Another consideration is the amount of resources available to manage the work. Typically, time and material contracts take more oversight to confirm that the amounts charged by the seller, both in terms of the number of units and the price per unit, are correct. Fixed price contracts takes less oversight. Risk allocation is also important. Fixed priced contracts allocate the most risk to the seller. In return, the seller owns the contingency and will likely charge a higher fee to absorb the added risk. Time and material contracts Represent the least risk to the seller and the most to the buyer. On the other hand, the buyer owns the contingency and the fee charged by the seller is typically less based on the lower risk. Based on the allocation of contingency fee and a fixed price contract, the contract price is the lowest cost we will pay for any contract. Any changes will likely increase the price of the contract. In a time and material contract, the cost to the buyer is lower if the seller uses less sources or does not require the contingency. But it can be higher if the opposite's true. Conversely, time and material contracts give the buyer the most control over the work and fixed contract, price is the least. The cost plus approach will usually fall between two extremes and the fixed fee and time and material approaches. It may represent a good compromise approach when you're looking at a mix of criteria. All of these factors should be considered when we make a decision on contract type to be used in a specific procurement activity. On many projects, all three types are used on different goods, services, or results. For instance, when we buy our goods on a fixed fee, our services on a cost plus basis and the report on a market on a time of material basis. All are valid approaches and we need to pick the right one.
