Outsourcing — Calculating the Cost of a Contract

calculating contract costsAs a project manager, you absolutely have to know how to calculate the cost of a contract. If all you use are straight fixed price contracts, the cost of the contract is fixed and you have nothing to calculate when making your outsourcing decisions. But if you are evaluating several contracts that are structured differently, you need to be able to figure out the bottom line of each. Without this ability, you really should just put some names in a hat and draw one one when selecting a vendor. Sound ridiculous? It is.

Let’s use some real world examples of a fixed price and a cost reimbursable contract. While I won’t provide an example of each type of fixed price and cost reimbursable contracts, the two examples I provide should give you enough of a base to determine contract cost on your own. I would suggest you also ask your Finance Department to get involved and double check your work.

Example 1. Cost Plus Incentive Fee

You have negotiated a contract with a vendor that is fixed price plus incentive. It has a target price of $600,000, a target incentive fee of $100,000, and ceiling price of $725,000. The share ratio you masterfully negotiated was 70/30, buyer to vendor. If the actual cost is $500,000, what is the projected cost of this contract?

1. Find the projected incentive. The projected actual cost of the contract is lower than the target price, so the vendor will receive an incentive for their performance. To calculate this, use the following formula:

Incentive = (target cost – actual cost) * vendor share ratio
Incentive = (600,000 – 500,000) * 30/100
Incentive = 100,000 * 0.3
Incentive = $30,000

2. Find the overhead fee.

Overhead fee = target incentive + incentive
Overhead fee = 100,000 + 30,000
Overhead fee = $130,000

3. Find the contract cost

Contract cost = actual cost + overhead fee
Contract cost = 500,000 + 130,000
Contract cost = $630,000

In this example, if the actual cost of the contract is $500,000, then the total contract amount will be $630,000. One way to use this information is to try and negotiate a different type of contract or terms of this one to save you money.

Example 2: Fixed Price Plus Incentive Fee with Cost Overrun

Let’s see what a cost overrun will do to an incentive contract. In this example we will use the following inputs:┬áIt has a target price of $100,000, a target profit of 10%, ceiling price of $130,000.The share ratio is 70/30, buyer to vendor, and the actual cost of $110,000. To determine the final cost of the contract, go through the following process:

1. Find the projected incentive. There was an overrun on the contract, so the incentive will be a negative number.

Incentive = (target cost – actual cost) * vendor share ratio
Incentive = (100,000 – 110,000) * 30/100
Incentive = -10,000 * 0.3
Incentive = -$3,000

2. Find the overhead fee.

Overhead fee = target fee + incentive
Overhead fee = 10,000 – 3,000
Overhead fee = $7,000

3. Find the contract cost

Contract cost = actual cost + overhead fee
Contract cost = 110,000 + 7,000
Contract cost = $117,000

The fixed price plus incentive fee contract can protect you as a buyer. Next time, I guarantee the vendor will work a little harder to make sure their cost projections are a little more accurate.

The Bottom Line

While this analysis does take into account contract costs, it does not take into account other variables like can the vendor provide your deliverables on time? Will they be able to meet your quality standards? Will they support their work if you have integration issues after delivery? Those variables need to be examined when making the final selection and factored in. Knowing how to compute the final cost of a contract will help you provide more value to your company and clients as a project manager.

Related Topics:
Types of Outsourcing Contracts
Outsourcing Components of Your Project
Implementation Archive

Mike Russell

Mike Russell

I am the author of this site, and what I say goes. I love talking about the benefits of formalized and professional project management and getting stuff done.

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About the Author

Mike Russell I am the author of this site, and what I say goes. I love talking about the benefits of formalized and professional project management and getting stuff done.