Selecting Type of Contract
Session 7
Definition: Contract
• A contract is a mutually binding
agreement which:
• obligates the seller to provide the
specified products, services, or
results, and
• obligates the buyer to provide
monetary or other valuable Level of Risk Transfer
consideration. Determined by the Type of
Contract used
Legal Aspects: Contract
Contract: Legal relationship Delegation of Procurement
subject to remedy in the courts Authority
Other names Only selected persons are authorized to sign
• Agreement contracts
• Subcontract
• Purchase order
• Memorandum of understanding
Contract and Risk
• Risk transfer is seeking to shift the consequence of
a risk to a third party together with ownership of
the response
• It does not eliminate the risk, it just transfers
responsibility for the risk
Transfer
Fixed Price Contracts
• Firm Fixed Price (FFP)
• Fixed Price Incentive Fee (FPIF)
• Fixed Price with Economic
Adjustment (FP-EPA)
Contract Cost Reimbursable Contracts
Types • Cost Plus Fixed Fee (CPFF)
• Cost Plus Incentive Fee (CPIF)
• Cost Plus Award Fee (CPAF)
Time and Material (T&M)
Contracts
5
Fixed Price 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 include incentives for early delivery, cost
savings, or technical performance
• Buyers must precisely specify the product or service to be procured
• Example of a fixed price contract is a purchase order
Risk
Buyer Seller
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
• Fee (% of direct cost) represents the seller’s profit
• May include incentives for meeting or exceeding selected project
objectives
Risk
Buyer Seller
Time and Material (T&M)
Contracts
• Hybrid type with aspects of both cost-reimbursable and of
fixed-price contracts
• Use for outside support when a precise statement of work
is not readily available
• Cost-reimbursable because the contract is open ended
• Fixed-price because unit rates are preset (ex. senior
engineer is $85/hour)
Risk
Buyer Seller
Allocation of Risk Through Contract Type
LOW HIGH
Fixed Price
- Firm Fixed Price (FFP)
- Fixed Price Incentive Fee (FPIF)
- Fixed Price with Economic Adjustment (FP-EPA)
Seller Risk
Buyer Risk
Cost Reimbursable
- Cost Plus Incentive Fee (CPIF)
- Cost Plus Fixed Fee(CPFF)
- Cost Plus Award Fee (CPAF)
Time and Materials (T&M)
HIGH LOW
Exercise
• Procurement Exercise – The Big Ideas Paint Job
• Group 1 – Fixed Price (Team A/Team B)
• Group 2 – Cost Plus (Team A/Team B)
• Group 3 – Time & Material (Team A/Team B)
Buyer’s Interest versus Seller’s
Interest
Scenario Buyer Seller
Bought at a higher rate Lose Win
Bought at a lower rate Win Lost
Procurement failure Lose Lose
Balanced Win Win
Incentives
Design contracts that align the interests of
buyers and sellers
Firm Fixed Price Example (FFP)
Estimated Actual #1 Actual #2
Cost $100,000 $80,000 $110,000
Price $110,000 $110,000 $110,000
$ 110,000
Profit $10,000 $30,000 -0-
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Fixed Price Incentive Fee Example: FPIF
Estimated Actual #1 Actual #2
Cost $100,000 $80,000 $110,000
Target Profit $10,000 $10,000 $10,000
Share Ratio 85/15 15% x 20,000 = 15% x -10,000 =
$3,000 -$1,500
Ceiling Price $115,000 $115,000 $115,000
$ 115,000
Price $110,000 $93,000 $115,000
Profit $10,000 $13,000 $5,000
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Cost Plus Fixed Fee Example: CPFF
Estimated Actual #1 Actual #2
Cost $100,000 $80,000 $110,000
% = 10% $10,000 $10,000 $10,000
Price $110,000 $90,000 $120,000
Profit $10,000 $10,000 $10,000
$ 10,000
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Cost Plus Incentive Fee Example: CPIF
Estimated Actual #1 Actual #2
Cost $100,000 $80,000 $110,000
Fee $10,000 $10,000 $10,000
$ 10,000
Sharing 85/15 15% x 20,000 = 15% x -10,000 =
Formula $3,000 -$1,500
Price $110,000 $93,000 $118,500
Profit $10,000 $13,000 $8,500
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Public Sector Practices in
Pakistan
• Contractors
• Unit Rate Contract - variant of Fixed price
• Unit Rates have provision for Economic Price Adjustment
• Quantity can vary
• Consultant
• Design Agreement is Percent Fee based: Fee is a percent of the value of the
construction contract
• Supervision is Duration based: Fixed monthly fee for duration of execution
Where is the Risk
tilted?
Buyer Seller 17
What type of Contract would
you pick?
We are planning to redo the office and
want to hire an Interior Decorator
Our Ice Cream business is growing
rapidly, we need to get another 60
specially fitted Ice Cream Vans
Government has issued new
environmental guidelines for effluent
disposal. We need to have an
assessment done on our existing
factories
Q&A