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Business LibreTexts

12.3: Selecting the Type of Contract

  • Page ID
    4951
  • Learning Objectives

    1. Identify factors that determine which type of contract to select.
    2. Describe the types of fixed cost contracts.
    3. Describe the types of cost reimbursable contracts.

    An agreement between the organization and an outside provider of a service or materials is a legal contract. To limit misunderstandings and make them more enforceable, contracts are usually written documents that describe the obligations of both parties.

    Because legal agreements often create risk for the parent organization, procurement activities are often guided by the policies and procedures of the parent organization. After the project management team develops an understanding of what portions of the project work will be outsourced and defines the type of relationships that are needed to support the project execution plan, the procurement team begins to develop the contracting plan. On smaller, less complex projects, the contract development and execution is typically managed through the parent company or by a part-time person assigned to the project. On larger, more complex projects, the procurement team can consist of work teams within the procurement function with special expertise in contracting. The contract plan defines the relationship between the project and the subcontractors (supplier, vendor, or partner) and also defines a process for making changes in the agreement to accommodate changes that will occur on the project. This change management process is similar to the change management process used with the project agreement with the project client.

    The contracting plan of the project supports the procurement approach of the project. The following are some factors to consider when selecting the type of contract:

    • The uncertainty of the scope of work needed
    • The party assuming the risk of unexpected cost increases
    • The importance of meeting the scheduled milestone dates
    • The need for predictable project costs

    There are several types of contracting approaches and each supports different project environments and project approaches. The legal contracts that support the procurement plan consist of two general types of contract: the fixed price and the cost reimbursable contracts, with variations on each main type.

    Fixed Price Contracts

    The fixed price contract is a legal agreement between the project organization and an entity (person or company) to provide goods or services to the project at an agreed-on price. The contract usually details the quality of the goods or services, the timing needed to support the project, and the price for delivering goods or services. There are several variations of the fixed price contract. For commodities and goods and services where the scope of work is very clear and not likely to change, the fixed price contract offers a predictable cost. The responsibility for managing the work to meet the needs of the project is focused on the contractor. The project team tracks the quality and schedule progress to assure the contractors will meet the project needs. The risks associated with fixed price contracts are the costs associated with project change. If a change occurs on the project that requires a change order from the contractor, the price of the change is typically very high. Even when the price for changes is included in the original contract, changes on a fixed price contract will create higher total project costs than other forms of contracts because the majority of the cost risk is transferred to the contractor, and most contractors will add a contingency to the contract to cover their additional risk.

    Fixed price contracts require the availability of at least two or more suppliers that have the qualifications and performance histories that assure the needs of the project can be met. The other requirement is a scope of work that is most likely not going to change. Developing a clear scope of work based on good information, creating a list of highly qualified bidders, and developing a clear contract that reflects that scope of work are critical aspects of a good fixed priced contract.

    Fixed Total Cost Contract

    If the service provider is responsible for incorporating all costs, including profit, into the agreed-on price, it is a fixed total cost contract. The contractor assumes the risks for unexpected increases in labor and materials that are needed to provide the service or materials and in the quantity of time and materials needed.

    Fixed Price with Price Adjustment

    The fixed price contract with price adjustment is used for unusually long projects that span years. The most common use of this type of contract is the inflation-adjusted price. In some countries, the value of its local currency can vary greatly in a few months, which affects the cost of local materials and labor. In periods of high inflation, the client assumes risk of higher costs due to inflation, and the contract price is adjusted based on an inflation index. The volatility of certain commodities can also be accounted for in a price adjustment contract. For example, if the price of oil significantly affects the costs of the project, the client can accept the oil price volatility risk and include a provision in the contract that would allow the contract price adjustment based on a change in the price of oil.

    Fixed Price with Incentive Fee Contract

    Fixed price with incentive fee is a contract type that provides an incentive for performing on the project above the established baseline in the contract. The contract might include an incentive for completing the work on an important milestone for the project. Often contracts have a penalty clause if the work is not performed according to the contract. For example, if the new software is not completed in time to support the start-up of a new plant, the contract might penalize the software company a daily amount of money for every day the software is late. This type of penalty is often used when the software is critical to the project and the delay will cost the project significant money.

    Incentive Fee on Copper Mine Project

    A project in South America to design and construct a copper mine would supply copper to several companies throughout the world. The copper that would be produced by the mine was sold before the mine was complete and ships were scheduled to make the delivery dates to processing plants.

    Any delay in the project would mean a delay in shipping and significant loss to the mine, the shipping company, and the plants that were expecting the copper. Including an incentive fee for completing the project on time and including the important subcontracts increased the likelihood that the mine would make copper deliveries on time.

    Fixed Unit Price

    If the service or materials can be measured in standard units, but the amount needed is not known accurately, the price per unit can be fixed—a fixed unit price contract. The project team assumes the responsibility of estimating the number of units used. If the estimate is not accurate, the contract does not need to be changed, but the project will exceed the budgeted cost.

    Fixed Unit Price Contract for Concrete

    An example of a fixed price contract is a contract for the concrete needed for the foundation of a building. The project contracted for the concrete company to supply 1,000 cubic yards (CY) at 5,000 PSI (hardness standard) of concrete at the project site according to, and in support of, the project schedule for $70 per square yard. This is an example of a unit price contract. If the project only uses 970 CY, then the total costs will be lower. If the project uses 1,050 CY, then the costs will be higher.

    An alternative pricing would be to establish a fixed price of $70,000 (1,000 CY × $70.00). Both the unit price approach and the total costs approach are fixed price contracts.

    Figure 12.7 Table of Fixed Price Contracts and Characteristics

    Type Known Scope Share of Risk Incentive for Meeting Milestones Predictability of Cost
    Fixed Total Cost Very High All Contractor Low> Very High
    Fixed Unit Price High Mostly Project Low High
    Fixed price with Incentive Fee High Mostly Project High Medium-high
    Fixed Fee with Price Adjustment High Mostly Project Low Medium