Question

You are buying a software package from a seller as well as the seller’s services to customize the software to meet your needs. You’ll also need to purchase training from the seller.

Explain the process that you would go through to determine the contract type(s) that you would select for this procurement and a brief rationale for such selection(s).

SUBJECT: PROJECT MANAGEMENT.

Answer 1

Introduction:

Procurement management helps you to identify a suitable supplier/contractor to procure goods and services. Procurement management has become a necessity for organizations these days.

Procurement management follows a logical order. First, you plan what you need to contract; then you plan how you’ll do it. Next, you send out your contract requirements to sellers. They bid for the chance to work with you. You pick the best one, and then you sign the contract with them. Once the work begins, you monitor it to make sure that the contract is being followed. When the work is done, you close out the contract and fill out all the paperwork.

You need to start with a plan for the whole project. Before doing anything else, you need to think about all of the work that you will contract out for your project. You will want to plan for any purchases and acquisitions. Here’s where you take a close look at your needs to be sure that contracting is necessary. You figure out what kinds of contracts make sense for your project, and you try to define all of the parts of the project that will be contracted out.

Contract planning is where you plan out each individual contract for the project work. You work out how you’ll manage the contract, what metrics it will need to meet to be considered successful, how you’ll pick a seller, and how you’ll administer the contract once the work is happening.

Contract & Contract Types:

A contract is a legally binding agreement between two or more parties. Usually, one party is known as a buyer and the other the seller. The contract is the key to the buyer and seller relationship. It provides a framework for how they will deal with each other.

Procurement contracts can be broadly divided into three categories:

1. Fixed-Price Contract
2. Cost Reimbursable Contract, and
3. Time and Materials

There is no hard-and-fast rule which governs the type of contract selected for any particular situation. As a project manager, it will be your job to choose a contract type to satisfy your needs best.

1. Fixed-Price Contract

A Fixed-Price contract is also known as a lump-sum contract. This type of contract is used when there is no uncertainty in the scope of work. Once the contract is signed, the seller is contractually bound to complete the task within the agreed amount of money and time. The seller bears the majority of the risk due to the nature of the contract, as he must provide for the completion of the work as stipulated in the contract.

1. A Fixed-Price contract can be further divided into three categories:
2. Firm-Fixed-Price contract (FFP)
3. Fixed Price Incentive Fee contract (FPIF)
4. Fixed Price with Economic Price Adjustment contracts (FP-EPA)

1. Firm Fixed-Price Contract (FFP)

This is the simplest type of procurement contract. In this type of contract, the fee is fixed. The seller has to complete the job within an agreed amount of money and time. Any cost increase due to the bad performance of the seller will be the responsibility of the seller, who is contractually bound to complete the job within the agreed amount. A Firm-Fixed-Price contract is mostly used in government or semi-government contracts where the scope of work is specified with every possible detail outlined. This type of contract is easy to float on the market, receive bids, and evaluate the bids primarily on a cost basis. Since the seller bears the risk, the cost tends to be higher. Another drawback of a Firm-Fixed-Price contract is possible disputes between the buyer and the seller if the scope is not clear. Moreover, any deviation from the original scope can cost you a lot.

2. Fixed-Price Incentive Fee Contract (FPIF)

In this type of contract, although the price is fixed, the seller is given an additional incentive based on his performance. This incentive lowers the risk borne by the seller. The incentive can be tied to any project metrics such as cost, time, or technical performance.

3. Fixed-Price with Economic Price Adjustment Contracts (FP-EPA)

A Fixed-Price with Economic Price Adjustment contract is used if the contract is multi-year long. Here, you include a special provision in a clause which protects the seller from inflation.

2. Cost Reimbursable Contract

This contract is also known as a Cost Disbursable contract. In this type of contract, the seller is reimbursed for completed work plus a fee representing his profit. Sometimes, this fee will be paid if the seller meets or exceeds the selected project objectives; for example, completing the task before time or completing the task with less cost, etc. A Cost Reimbursable contract is used when there is uncertainty in the scope, or the risk is higher. In this contract, since the buyer pays for all cost, he bears the risk. Scope Creep is an inherent drawback of a Cost Reimbursement Contract, especially when the requirements are unclear. The seller will always try to elevate the cost because it will be tied to some fee or reimbursement. This difficulty can be minimized with proper management of the contract and capping the seller’s profit.

Cost Reimbursable contracts can be further divided into four categories:

1. Cost Plus Fixed Fee contract (CPFF)
2. Cost Plus Incentive Fee contract (CPIF)
3. Cost Plus Award Fee (CPAF)
4. Cost Plus Percentage of Cost (CPPC)

1. Cost Plus Fixed Fee Contract (CPFF)

In this type of contract, the seller is paid for all incurred costs plus a fixed fee (which will not change), regardless of his performance. Here, the buyer bears the risk. This type of contract is used in projects where the risk is high, and no one is interested in bidding. Therefore, this type of contract is selected to keep the seller safe from risks.

2. Cost Plus Incentive Fee Contract (CPIF)

In a Cost Plus Incentive Fee contract, the seller will be reimbursed for all costs plus an incentive fee based upon achieving certain performance objectives mentioned in the contract. This incentive will be calculated using an agreed on a predetermined formula. Here, the risk also lies with the buyer; however, this risk is lower than the Cost Plus Fixed Fee where the buyer has to pay a fixed fee along with the cost incurred. In a Cost Plus Incentive Fee contract, the incentive is a motivating factor for the seller. The seller may get some incentive if he can complete the work with less cost or before time. Most of the time the incentive is a percentage of the savings, which is shared by the buyer and the seller.

3. Cost Plus Award Fee (CPAF)

Here, the seller is paid for all his legal costs plus some award fee. This award fee will be based on achieving satisfaction according to specified performance objectives described in the contract. The evaluation of performance is a subjective matter, and you cannot appeal it. Note: There is a difference between the incentive fee and the award fee. An incentive fee is calculated based on a formula defined in the contract and is an objective evaluation. An award fee is dependent on the satisfaction of the client and is evaluated subjectively. Award fee is not subjected to an appeal.

4. Cost Plus Percentage of Cost (CPPC)

Here, the seller is paid for all costs incurred plus a percentage of these costs. The buyer does not prefer this type of contract because the seller might artificially increase the cost to earn a higher profit.

3. Time and Materials Contract

This is a hybrid contract of Fixed-Price and Cost Reimbursable contracts. Here, the risk is distributed to both parties. A Time and Materials type of contract is generally used when the deliverable is “labor hours.” In this type of contract, the project manager or the organization will provide the required qualification or experience to the contractor who is responsible for providing the staff. This type of contract is used to hire some experts or any outside support. Here, the buyer can specify the hourly rate for the labor with a “not-to-exceed” limit.

Which Type of Contract to be use?

Selecting the contract type is a crucial decision for a project manager. It determines your relationship with the seller and mitigates risk.

You should always select a contract which provides the optimum value for your time and money and protects your project from any risks. You should go for a Fixed-Price contract if the scope of work is well defined and fixed. However, you should choose the Cost Reimbursable contract if the project scope is not fixed and is exploratory.

You should go for the Time and Materials type of contract if you require only expert opinions, consultancy service, or outside support.