Project Contract Types

Contracts are legally binding agreements between at least 2 different legal entities named a buyer and a seller. The buyer wishes to buy certain goods or services from a seller. The seller, in return for the goods or services provided, expects monetary or other values to be paid to them.

When a buyer and seller agree to work together as mentioned above, both sides will have an expectation to receive some value from the other party. And both sides also have certain obligations to fulfill towards each other. A legally binding contract will help protect the rights of both sides by ensuring both sides fulfill their obligations. In case of any issues, any of the aggrieved sides can take legal recourse.

Elements of a Legally Binding Contract

A contract is an elaborate document containing the detailed scope of work along with all other agreed terms and conditions, stating the rights and obligations of both sides.

A legally binding contract will have the following components:

1. There must be an offer from one side. The offer must be genuine offer.
2. There must be accepted from the other side. The acceptance must be a willing acceptance without any kind of pressure.
3. There must be an equal exchange of values between both sides.
4. Must be signed by authorized personnel.
5. The work in the contract must be legally allowed work. There can’t be a legal contract for illegal work.

While all the above elements must be present in a legally binding contract, it is said that consideration is the most important factor, as that defines the benefits received by both sides. It is also said that the consideration must be win-win for both sides. Skills learned during their PMP certification training help managers get the best out of these legalities.

Contract Types

There are three broad categories of contracts as mentioned below:

1. Fixed Price Contract (FP)
2. Time and Material Contract (T&M)
3. Cost Reimbursable Contract (CR)

Fixed Price Contract

Fixed Price contracts are used when the scope of work is clearly defined and the requirements are well understood. Once the scope is clearly defined, then it is expected that the seller will come up with a fixed price quotation for the agreed scope of work. The seller needs to understand the requirements and also all the associated risks which may occur during the project work while making a fixed prices quotation. Hence for a fixed prices contract the seller also needs to be very mature and capable.

Once agreed, it becomes a win-win for both sides. The buyer is assured of a fixed price to be paid once the defined scope of work is completed by the seller. The payments will be made based on delivering well-defined outcomes. The seller here assumes all the cost-related risks once agreed. The seller may lose money in this kind of contract, but at the same time, the seller may make a maximum profit also in this kind of contract if they can complete the work at less cost.

It will take solid maturity and clarity on both sides to come up with fixed-price contracts. Negotiation may take some time. Fixed price contracts once finalized, will use change requests for any kind of changes to be made in scope or any other terms and conditions.

There are 3 different flavors of fixed-price contracts as below:

1. Firm Fixed Price Contract (FFP)
2. Fixed Price with Incentive (FPIP)
3. Fixed Price with Economic Price Adjustment (FP-EPA)

Firm Fixed Price Contract (FFP)

1. Definition: A fixed price that is non-negotiable and not subject to any adjustments.
2. Risk: The contractor bears the maximum risk for any cost overruns.
3. Advantage: Offers maximum cost certainty for the project owner.

Fixed Price with Incentive (FPIP)

1. Definition: This is a contract where the contractor is incentivized by the client upon meeting or exceeding project goals.
2. Incentives: Rewards are given for cost savings or early completion.
3. Advantage: Encourages efficiency and aligns contractor objectives with project goals.

Fixed Price with Economic Price Adjustment (FP-EPA)

1. Definition: A Fixed Price with Economic Price Adjustment contract allows for price adjustments based on specific economic conditions such as inflation or changes in material costs.
2. Use Case: Long-term projects where economic conditions may fluctuate.
3. Advantage: Protects both parties from significant economic changes.

Time and Material Contract (T&M)

Time and Material contracts are very popular contract type which is used for regular purchases of standard items. Items may include augmenting temporary manpower for the project with well-defined skills and expertise levels. Item also includes standard materials which may be needed for consumption in the project.

In T&M contracts, the organization will select some preferred suppliers of such manpower and materials. The vendors will be selected based on their capabilities and experience. There will be a negotiated price (or rate) for such supplies. The final price paid will be for the amount of quantity of such resources consumed or purchased.

Managing T&M contracts is pretty simple. T&M contract uses both the flavors of fixed price and reimbursement based on consumption.

Cost Reimbursable Contract (CR)

In cost reimbursable contract the buyer pays the actual cost incurred by the seller and an additional fee or profit. There are 2 components paid separately in this kind of contract. While the actual cost is reimbursed as per actual, the fee amount is somewhat decided upfront.

This kind of contract is used when the requirements are not clear. The team also does not have much clarity about the details of how the product will be developed. Hence in absence of clarity on all accounts, this becomes the best possible arrangement.

Cost reimbursable contracts are used for new research and development, and proof of concept developments which require immense innovation without a guarantee of the predicted outcome.

Following are some of the flavors of Cost-Reimbursable contracts.

1. Cost plus a percentage of the cost (CPPC)
2. Cost plus fixed fee (CPFF)
3. Cost plus Incentive Fee (CPIF)
4. Cost plus award fee (CPAF)

Cost plus contracts put all the risk on the buyer, as the seller is assured of all the actual costs plus some fees. The entire responsibility lies on the buyer. These contracts sometimes can be misused also. As the seller will not bother much about cost control, as they are assured of all actual costs. This requires the buyer to audit and micro-manage all the expenses.

a. Cost Plus a Percentage of the Cost (CPPC)

1. Definition: The contractor is reimbursed for costs and receives an additional percentage of these costs as profit.
2. Risk: Can lead to higher costs for the project owner.
3. Advantage: Ensures the contractor covers costs and makes a profit.

b. Cost Plus Fixed Fee (CPFF)

1. Definition: The contractor is reimbursed for costs and receives a fixed fee for profit.
2. Stability: The fixed fee does not vary with actual costs.
3. Advantage: Encourages cost control while ensuring a guaranteed profit.

c. Cost Plus Incentive Fee (CPIF)

1. Definition: The contractor is reimbursed for project costs and receives an incentive fee based on performance metrics such as cost savings or timely completion.
2. Incentives: Aligns contractor’s interests with the project owner’s goals.
3. Advantage: Encourages efficiency and high performance.

d. Cost Plus Award Fee (CPAF)

1. Definition: The contractor is reimbursed for all project costs, plus an award fee determined based on the contractor’s performance.
2. Performance: The award fee incentivizes high standards in areas like quality, schedule adherence, and cost management.
3. Advantage: Encourages excellence and high performance standards.

Conclusion

The above contract types are used worldwide. Specific contract types can be used for specific kinds of purchases. Contracts have legal binding on both sides that are part of the contract.