2.8T Techniques / Basics of Contracts

Choose the Correct Contract Types for your Project (2.8T.P1)

There are a number of standard contract types to guide the relationship between buyers and sellers. There are also many variations on these basic contract types. These contract types are categorized based on the amount of risk each party agrees to accept. The buyer’s objective is to place maximum performance risk on the seller, while maintaining incentive for economical and efficient performance. The seller’s objective is to minimize risk while maximizing profit potential. The three broad categories of contracts are Cost Reimbursable, Fixed Price and Time and Material (T&M).

Cost-Reimbursable (CR) (2.8T.P2)

These contract types pay the seller for the product. In the payment to the seller there is a profit margin, which is the difference between the actual costs of the product and the sales amount. The actual costs of the product fall into two categories:

  • Direct costs – Those costs incurred by the project in order for the project to exist. Examples include equipment needed to complete the project work, salaries of the project team, and other expenses tied directly to the project's existence.

  • Indirect costs – Those costs attributed to the cost of doing business. Examples include utilities, office space, and other overhead costs.

The following example shows the general model for cost reimbursable contracts.  

Cost Plus Incentive Fee (CPIF) example

Actual Cost + Target Fee + ((Target Cost - Actual Cost) * Share Ratio)  

Target Cost              $100,000

Target Fee               $10,000

Share Ratio               80/20

Actual Cost               $80,000

The Seller receives $94,000, which is calculated as

$80,000 + $10,000 + ((100,000 - 80,000) * 20%)

There are a number of common variations of this contract type including

  • Cost Plus Fixed Fee (CPFF). A CPFF contract provides for reimbursement of allowable costs, plus a fixed fee paid proportionately as the contract progresses. Although there is a ceiling on the seller’s profit, there is no motivation to control costs, so that most risk remains with the buyer. This contract type is used predominantly for research and development projects where the effort required remains uncertain until the project is well under way.

  • Cost Plus Percentage of Cost (CPPC). A CPPC contract provides for reimbursement of allowable cost of services performed, plus an agreed-upon percentage of the costs as profit. The seller is obligated only to make its best effort to fulfill the contract within the estimated amount; the buyer funds all overruns. This contract type is prohibited in U.S. federal contracting and is only rarely used in the commercial sector.

  • Cost Plus Incentive Fee (CPIF). A CPIF contract provides for reimbursement of allowable cost plus a predetermined fee as a bonus for superior performance. If actual cost is less than expected cost, the buyer and seller share in the savings, based on a predetermined formula. This type is used predominantly for contracts with long performance periods and substantial hardware development and test requirements.

Fixed Price (FP) Contracts (2.8T.P3)

This is the most common form of contract and is appropriate when the buyer can describe the scope of work. These can also include incentives for meeting or exceeding project objectives. When incentives are present, there is a ceiling price included. This type of a contract has the least cost risk for the buyer.

  • Firm Fixed Price (FFP) An FFP contract is a lump-sum contract under which the seller furnishes goods or services at a fixed price. The seller bears all risk, but is compensated with the greatest profit potential. This is the most common contract type, and is best suited for situations with reasonably definite specifications and relatively certain costs.

  • Fixed Price Incentive Fee (FPIF). A FPIF contract provides the seller with a fixed price plus a predetermined fee as a bonus for superior performance. Both buyer and seller share risk. This type of contract is used primarily for high-value projects involving long performance periods, such as for shipbuilding and major systems development projects.

The following example shows the general model for cost reimbursable contracts. 

Actual Cost + Target Fee + ((Target Cost - Actual Cost) * Share Ratio))  

Target Cost    $125,000

Target Price    $150,000

Target Fee      $25,000

Ceiling Price    $175,000

Share Ratio     80/20

Actual Cost     $100,000

The Seller receives $130,000 which is calculated as follows.

$100,000 + $25,000 + ((125,000 - 100,000) * 20%)

Now, we'll take the same example where the actual cost is $175,000:

$175,000 + 25,000 + ((125,000 - $175,000) * 20%)

$200,000 + (-$50,000 * 20%) = $190,000?

The ceiling price is now a factor because of the cost overruns in the actual cost. The buyer is only obligated to pay the agreed upon ceiling price of $175,000.

Time and Material (T&M) (2.8T.P4)

This is a combination of the Cost Reimbursable and the Fixed Prices. It usually addresses project work that has no definite end (variable) but the cost is a unit price (hour or unit). The total cost is unknown and it varies with time and/or materials.

Contract Risks (2.8T.P5)

The following chart describes the level of risks for buyers and seller for each contract type.

Contract Statement of Work (2.8T.P6)

In many cases you do not know the specific nature of the work until you are closer to the execution of the work. In these cases it is common to establish a master contract between the client and the vendor, and then create a Statement of Work (SOW) to fully describe the actual work and the deliverables to be completed. It should also describe how the project product or service is to be supported. The SOW becomes part of the contract between the buyer and the seller. 

Point of Total Assumption (2.8T.P7)

The price determined by a Fixed Price Incentive Fee (FPIF) contract which the seller bears all the loss of a cost overrun. Once the costs reach the Point of Total Assumption, the agreed to ceiling price is the maximum amount the buyer will pay. This is the price point in the contract above which the seller assumes responsibility for all additional costs.

Contract Incentives (2.8T.P8)

Incentives in a contract provide a "carrot" for the contractor in an attempt to bring the objectives and interests of the contractor in line with those of the buyer. Experience has shown that contract incentives are indeed usually cost effective. Incentives can be structured in a variety of ways and are flexible in that they can be used in conjunction with any of the types of contracts.

Elements of a Legally Enforceable Contract (2.8T.P9)

Mutual assent, consideration must be provided to both parties (sufficient cause to contract), signing parties must have legal right to contract, the contract must have a legal purpose, and the contract must not violate public policy.

In order for a contract to be valid, it must:

  • Contain an offer

  • Have been accepted

  • Provide for a consideration (payment)

  • Be for a legal purpose

  • Be executed by someone with capacity and authority

Typical Terms in a Contract (2.8T.P10)

The terms and conditions of the contract should define aspects of the engagement such as:

  • Delivery schedule

  • Payment schedule

  • Method for determining the price

  • Handling of changes

  • Warranties

  • Insurance

  • Inspections

  • Delays

  • Termination

  • Subcontracts

  • Performance bonds

  • Results of Contract Administration

  • Payment Requests and schedules

  • Correspondence

  • Requested changes

  • Performance evaluations

  • Standard clauses. The use of standard clauses is encouraged where possible because they are legally sufficient for most contractual situations and because they cost less (customized contract language takes time and can sometimes be expensive to develop).

    • Changes to the contract

      • Control of change

      • Who initiates a change request

      • How change is funded

      • Final approval authority

      • Configuration control

    • Warranties

      • Establish a level of quality

      • Express warranty- Contract explicitly states what the level of quality is

      • Implied warranty - Contract describes “merchantability” or “fitness of use”

    • Doctrine of waiver. The relinquishing of one party’s contract rights because of lack of enforcement of those rights

    • Delays. Describe what will happen based on

      • Who caused it

      • Nature of the interruption

      • Impact

    • Bonds

      • Performance bond - secures for the buyer the performance and fulfillment of the contract

      • Payment bond - Guaranteed payment to subcontractors and laborers by the prime or the guarantor

    • Breach

      • Failure to perform a contractual obligation

      • Measure for damage is the amount of loss sustained by an injured party

      • Material breach - more serious than a contract breach. Non-faulted party discharged from any further obligations—for example, when a contract stipulates that time is of the essence, failure to perform within the allotted time constitutes material breach and the project manager will not be required to accept late performance

Sole Source Contracts (2.8T.P11)

It is generally considered a good practice to ensure competition among a group of prospective contractors if possible. There is considerable literature documenting the benefits of competition. However, there are conditions under which it makes sense to allow noncompetitive contractor selection, which include the following:

  • When a contractor truly has a unique qualification that cannot be found or matched elsewhere

  • When other mechanisms exist to ensure that the price you are paying is reasonable. For example, you might have the in-house expertise to properly evaluate the contractor’s bid for reasonableness and accuracy

  • When your project is under extreme schedule pressure, competitive source selection almost always takes longer, because you must allow time to prepare a solicitation document, time for sending and receiving the solicitation, time for the prospective contractors to prepare and submit a proposal, and time for you to evaluate them all and make a selection

The contract negotiation process is an activity to create a fair price for the work the seller is to complete. The performing organization creates an offer and sends it to the seller. The seller then considers the offer. The performing organization and the seller must be in agreement on the expectations, requirements, authorities, terms, technical and business management approaches, price and any other pertinent factors covered within and by the contract prior to signing the contract. The final contract can be a revised offer by the seller or a counter offer by the buyer.

Privity of Contract (2.8T.P12)

Privity of contract is a legal term that recognizes that the contractual relationship exists between a buyer and its prime contractor. No contract exists between the buyer and the subcontractors, and it is legally improper for a buyer to bypass a contractor and deal directly with a subcontractor(s).

Beyond the legal issue, there are other reasons for a buyer to be cautious about dealing with subcontractors. In doing so, the buyer may inadvertently relieve the prime contractor of certain responsibilities. For example, if a buyer informs a subcontractor that things might work better if the subcontractor would “try the following approach...” and the subcontractor runs into trouble, the prime contractor may rightfully claim that the buyer’s interference caused the problems.