When looking to outsource one of the widgets of your project, there are several types of contracts that you can use to protect yourself and your company. Determining the type of contract should be part of your Make or Buy Analysis because the final cost of a contract will depend on how it is structured. Trying to determine what those costs will be is your job as the project manager. If your specialty as a PM is to work with outside clients who hire your company to produce widgets, this discussion is also relevant to you.
There are three types of contracts that are used in business. Each has its own variation that could help control costs and motivate your vendor to deliver your widgets on time. They are commonly called a Fixed Price Contract (FP), Cost Reimbursable Contract (CR), and Time and Materials Contract (T&M). Each industry has their preference of which type of contract to use and as a PM you should familiarize yourself with each. In my experience, the CFO or Finance Director of your organization will have a very strong opinion on which option they prefer. I like to give them options and present them with the financial implications of each so they can make their decision based on the best information available.
These are the most common Fixed Price contracts:
Fixed Price: This is what most people think of when they hear the word contract. Using a pure FP contract, the buyer pays the vendor a fixed price for a good or service as long as the acceptance criteria are met. The price does not change.
Fixed Price Plus Incentive Fee: The vendor and the buyer set a target price and a ceiling price. The ceiling price is the cap of what the buyer would pay for the widget. Any cost overruns above the ceiling price are absorbed by the vendor. As part of the contract the buyer agrees to pay the vendor a pre-set percentage of the difference between the target price and the vendor’s actual costs. The incentive for the vendor is to curb the contract amount below the target price to increase the amount earned.
Fixed Price Plus Award Fee: When quality is a concern, you might use this type of contract. The vendor and buyer set a price for the contract. You would also set a criteria to determine the quality of work and pay an additional award amount when quality standards are met.
Here are the most common Cost Reimbursable contracts:
Cost Plus Fixed Fee: The most common type of CR contract. Here the buyer reimburses the vendor for the costs of executing the contract and a fixed fee.
Cost Plus Incentive Fee: Like the FP Plus Incentive fee, the vendor and the buyer set a target price and a ceiling price. Costs above the ceiling price are borne by the vendor. It works much like the FP version, but the vendor is reimbursed for costs of executing the contract instead of a predetermined amount.
Cost Plus Award Fee: Works like the FP version of this contract. The difference is the vendor reimburses for costs instead of a set amount.
Here are the details on Time and Materials contracts:
Theoretically the T&M contract combines the best of both worlds for the vendor and the buyer. I haven’t ever used on because my projects typically are not in the construction industry. Using this type of contract, the buyer agrees to reimburse the vendor for all time and materials plus a fee per unit. It is important to define how the T&M will be calculated and what will be included. You can put a ceiling on the total of the contract to protect yourself as the buyer.
In another post we will discuss how to calculate the actual cost of a contract using several variables and contract types. As a PM, you have to know what the total possible financial exposure your company faces in any type of contract. If you have a firm grasp on how to calculate the bottom line of any contract, you will be able to make better decisions when it comes to awarding contracts to vendors if you are a buyer. If you are a vendor, having this knowledge will help you structure your contracts so that your company is fairly compensated for the work performed.