Contract Types

Common types of contracts used in project procurements

There are three main types of contracts:

  • Fixed Price or Lump Sum
  • Cost-Reimbursable
  • Time and Material (T&M) - hybrid of the above two types

Fixed Price (FP)

  • Also known as Lump Sum
  • Used when scope of work is clear
  • Buyer doesn’t have time to audit invoices
  • Most cost risk for seller - as the seller’s effort increases, the project cost remains constant, but the seller’s profit continues to fall
  • Three sub types:
    • Firm Fixed Price (FFP)
      • A type of fixed price contract where the buyer pays the seller a set amount (as defined by the contract), regardless of the seller’s costs
      • Price is firm
      • Most preferred by buyers around the world
      • Cost, performance and time are equally important constraints
    • Fixed Price Incentive Fee (FPIF)
      • Performance incentives
      • Cost is measured to determine the incentive fee; therefore, cost is the most important constraint
      • Performance is the second important constraint
      • Time is the least important constraint
      • Sets a ceiling price for the seller
      • Uses parameters such as ceiling price, total price, award fee and fee criteria
      • The total cost on a FPIF contract, above which the seller bears all cost overruns is known as the Point of Total Assumption
    • Fixed Price with Economic Price Adjustment (FP-EPA)
      • A fixed-price contract, but with a special provision allowing for predefined final adjustments to the contract price due to changed conditions, such as inflation changes, or cost increases (or decreases) for specific commodities.
      • Adjusts the contract prices for currency fluctuations, inflation, raw material cost, and labor rate changes
      • Used when contract spans multiple years
      • Protects both buyer and seller

Cost Reimbursable (CR)

  • A type of contract where the buyer reimburses the seller for the seller’s actual costs, plus a fee representing the seller’s profit
  • Scope of work is not clear
  • Higher cost risk for buyer
  • Full value of the contract not defined upfront
  • Buyer needs to audit invoices
  • Suitable for:
    • High-risk work
    • R&D type work
  • Three sub types:
    • Cost Plus Fixed Fee (CPFF)
      • A type of cost-reimbursable contract where the buyer reimburses the seller for the seller’s allowable costs (allowable costs are defined by the contract) plus a fixed amount of profit (fee).
      • Does not provide any motivation for the seller to control costs - Buyer beware!!!
      • Although there are no incentives for efficiency in time or performance, there may be penalties for bad performance; therefore, performance is the most important constraint
      • Time is the second most important constraint
      • Cost is the least important constraint
    • Cost Plus Incentive Fee (CPIF)
      • A type of cost-reimbursable contract where the buyer reimburses the seller for the seller’s allowable costs (allowable costs are defined by the contract), and the seller earns its profit if it meets defined performance criteria
      • The criteria for determining seller fee is defined in objective terms
      • Cost is the most important constraint
      • Performance is the second most important constraint
      • Time is the least important constraint
      • Most appropriate if the buyer expects the product to be built with the best quality material available, in the shortest possible time
      • Uses parameters such as target cost, target fee, target price and share ratio
    • Cost Plus Award Fee (CPAF)
      • A type of cost-reimbursable contract that involves payments to the seller for all legitimate actual costs incurred for completed work, plus an award fee representing seller profit
      • The criteria for determining seller fee is defined in subjective terms
      • Performance is the most important constraint
      • Time is the second most important constraint
      • Cost is the least important constraint
      • Uses parameters such as target cost, target fee, target price, award fee, and fee criteria

Time and Material (T&M)

  • A type of contract that is a hybrid of cost reimbursable (CR) and fixed price (FP) contracts
  • Higher cost risk for buyer
  • Mainly used for staff augmentation
  • Suitable when work needs to start soon
  • Cost is the most important constraint
  • Buyer wants the control
  • Time is the second most important constraint
  • Performance is the least important constraint

Cost Risk in Contracts

Point of Total Assumption

  • The total cost on a Fixed Price Incentive Fee (FPIF) contract, above which the seller bears all cost overruns
  • The point at which a Fixed Price Incentive Fee (FPIF) contract becomes a Firm Fixed Price (FFP) contract

Read the 5-part series on Point of Total Assumption to get a detailed understanding of this topic.

Q&A

  1. What is the difference between Cost Plus Fixed Fee (CPFF) contract and Cost Plus Incentive Fee (CPIF) contract?

    In both these contracts, the seller is reimbursed for the allowable costs of project work. However, in CPFF, the seller fee is fixed and is not tied to the seller’s performance, whereas in CPIF, the seller fee is tied to the seller’s performance.

  2. What is the difference between Cost Plus Incentive Fee (CPIF) contract and Cost Plus Award Fee (CPAF) contract?

    In CPIF, the criteria for determining seller fee is defined in objective terms, whereas in CPAF, the criteria is subjective.

Last updated: October 08, 2018