Questions related to procurement management, especially contract management, are among the most popular questions in the PMP exam. So you must know the differences between the different types and categories of contracts and the appropriate case for using each type or category.
Most contracts related questions are
Explanation of the situation and asking what type of contract is appropriate in this situation?
Determining a specific type of contract and asking about the risks or the cost of the contract.
We will answer these questions at the end, but we must first know the categories and types of contracts
Contract Categories
Fixed Price Contracts
In this category of contracts a fixed total price is set for a specific product or service. This type is used when the requirements are initially well defined, and significant changes to these requirements are not expected. This type of contract is considered the least risk to the buyer and the highest risk to the seller, because the price is fixed and determined at the beginning. This category includes several types:
Fixed Price Contract (FFP) The price is determined at the beginning and does not change except with the change in the scope of work. Example contract value = $20,000
Fixed Price Incentive Fee (FPIF) A fixed price is initially set with some flexibility by adding an incentive amount in the contract if a certain result is achieved. For example, if the project is completed earlier than the pre-determined date, the seller receives a certain incentive for each month before the project deadline. Example contract value = $50,000 with an incentive of $2,000 for each early month in which the project is completed before the pre-determined date, with a maximum of $10,000
Fixed Price Economic Price Adjustment (FPEPA) This type is used in long-term contracts that may need some adjustments according to economic conditions such as the exchange rate or the inflation rate. For example, the contract value = $2,000,000, and it may be allowed to adjust after the first year based on the dollar exchange rate.
Time and Material (T&M) contracts
In this category, the contract is made between the seller and the buyer based on a certain number of working hours, and the seller receives fee according to the hours in which the work is completed, or depending on the number of items purchased. Like supplying of 5 tons of cement, the price is paid according to what was agreed upon. This category is used for short-term contracts when an accurate statement of work cannot be prepared in advance, or with an increase in the number of employees in the recruitment of experts and any external support. A “Not to exceed” clause may be added to reduce the risk to the buyer by setting a maximum amount that the seller will receive. Example An expert will be hired at $100 per hour with a maximum of $10,000
Cost Reimbursable Contracts
In this category the buyer pays the seller all the costs of the work incurred by the seller plus a fee representing profit for the seller specified in the contract. This category of contracts is used for businesses where a significant change in scope is expected or if the scope is unclear or little information is available. This category includes several types, including:
Cost Plus Fixed Fee The seller gets all the cost of the work created with a fixed amount representing the seller's profit. Example Contract value = Cost + $10,000
Cost Plus Percentage of Cost The seller gets the cost of the work he has done in addition to a percentage of these costs as a fee to the seller. It is considered one of the worst types of contracts for the buyer, because the seller's fee will be a percentage of the cost. Therefore, the seller will increase the cost to increase his profit. Example Contract value = Cost + 10% of the cost as wages to the seller
Cost Plus Incentive Fee The seller gets the cost of work done plus a predetermined incentive amount based on achieving certain performance goals as stated in the contract. If the final costs are less or greater than the original estimated costs, the costs from the projects are shared by both the seller and the buyer based on a pre-negotiated cost-sharing formula. Example contract value = Desired cost $200,000 + Desired profit $20,000. Any increase or cost savings will be shared between the seller and buyer by 80/20.
Cost Plus Award Fee The seller receives the cost of the work he has done in addition to an amount he gets based on fulfilling certain performance criteria specified in the contract. Example Contract value = Cost + Profit amount to the seller + $5000 for each month in which production exceeds 100,000 units.
To answer the previous questions
If the scope is specified from the beginning, or the contracted work is known, has been done before, or will not include changes, etc., fixed-price contracts are more suitable.
If the contracted work is complex or has not been done before or includes risks or may include changes...etc., cost reimbursable contracts are more suitable.
If the contracted work is a small business, supplying materials, bringing in experts, or urgent work for an emergency situation, or there is no time to prepare a detailed statement of work, or for the current seller’s circumstances, to leave the business and want a new seller or supplier as soon as possible .. etc. Time and material contracts are more suitable.
The order of the contracts in relation to the risks from lowest to highest for the seller isCPPC - CPFF - CPAF – CPIF- T&M - FPEPA - FPIF - FFP
On the contrary, for the buyer, the contracts are arranged according to the risks, from lowest to highest, as follows
FFP - FPIF - FPEPA - T&M - CPIF - CPAF - CPFF - CPPC
