Contract Types and Risks

Contract Type

In negotiating a contract, it is the buyer's objective to maintain an incentive for efficient and economical performance while placing maximum risk on the seller. The objective of the seller is to maximize the profit potential while minimizing the risk. Contracts generally fall into one of three broad categories:

Fixed price or lump sum contracts
Fixed total price for a well-defined product
If the product is not well-defined, both the buyer and seller are at risk
Fixed price contracts may also include incentives
Cost reimbursable contracts
Payment (reimbursement) to the seller for actual costs
Costs are classified as direct costs or indirect costs
Direct costs are costs incurred for the exclusive benefit of the project
Indirect costs (overhead costs) are costs allocated to the project by the performing organization
May include incentives for meeting or exceeding selected project objectives
Unit price contracts
Preset amount per unit of goods or service
Total value of the contract is a function of the quantities needed

Cost-Plus-a-Percentage-of-Cost (CPPC):

Seller is reimbursed for allowable costs of performing the contract and receives a profit (a fee) an agreed upon percentage of the costs.
No limit on the seller’s profit. If the seller’s cost increases, so does the profit.
Most undesirable type of contract from buyer’s standpoint.
Prohibited for federal government use. Used in private industry, particularly construction projects.
Susceptible to abuse. No motivation for seller to decrease costs.
The buyer bears 100% of the risk.
The buyer project manager must pay particular attention to the control of the labor and material costs so that the seller does not purposely increase these costs.
Bottom line: no limit on seller’s profit!

Cost-Plus-Fixed Fee (CPFF):

Seller is reimbursed for allowable costs of performing the contract and receives as profit a fixed fee payment based on the percentage of the estimated costs.
The fixed fee does not vary with actual costs unless the scope of work changes.
Susceptible to abuse in that there is a ceiling on profit, but no motivation to decrease costs.
Primarily used in research projects where the effort required to achieve success is uncertain until well after the contract is signed.
Bottom line: limit on profit but no incentive to control costs.

Cost-Plus-Incentive Fee (CPIF):

Seller is paid for allowable performance costs along with a predetermined fee and an incentive bonus.
If the final costs are less than the expected costs, both the buyer and seller benefit by the cost savings based on a pre-negotiated sharing formula.
The sharing formula reflects the degree of uncertainty faced by each party.
Primarily used when contracts involve a long performance period with a substantial amount of hardware development and test requirements.
Risk is shared by both buyer and seller.
Bottom line: provides incentive to seller to reduce costs by increasing profit potential.

Fixed Price-Plus-Incentive Fee (FPI):

Most complex type of contract.
Consists of target cost, target profit, target price, ceiling price, and share ratio.
For every dollar the seller can reduce costs below the target cost, the savings will be shared by the seller and buyer based on the share ratio.
The share ratio is a negotiated formula that reflects the degree of uncertainty faced by each party.
If the costs exceed the ceiling price, the seller receives no profit. Regardless of the actual costs, the buyer pays no more than the ceiling price.
Risk is shared by both buyer and seller, but risk is usually higher for the seller.
Usually used when contracts are for a substantial sum and involve a long production time.
Bottom line: provides incentive to decrease costs which in turn increases profits. If costs exceed a ceiling, then the contractor is penalized.

Firm-Fixed Price (FFP):

Seller agrees to perform a service or furnish supplies at the established contract price.
Will also be called lump sum.
Seller bears the greatest degree of risk.
Seller is motivated to decrease costs by producing efficiently.
Best specifications are available and costs are relatively certain.
Common type of contract.

Cost-Plus-Award-Fee (CPAF):

An award pool is created. The level of award is determined by an award committee.
Buyers have more flexibility with CPIF. Subjective judgments can be used to determine rewards (such as a contractor’s attitude).
Type of contract is gaining popularity.
Downside: administrative cost is high due to award committee.

Contract Incentives

Contract incentives are fundamentally designed to provide motivation for desired performance. There is growing recognition that contract incentives are valuable tools to motivate the desired performance.
Incentives can be objectively based and evaluated or subjectively based and evaluated:
Objectively based and evaluated are tied to performance areas like cost, schedule or delivery, and quality.
Subjectively based and evaluated involve award fees and other special incentives.