Contract management is typically a major effort in the life of the project and can have huge impact on the project’s final success.
As part of planning a project, the scope is analyzed to determine whether or not internal resources can do the project scope. If not, then the work is outsourced. Well, outsourcing project work requires the procurement process. Procurement is the formal process to obtain goods and services.
Private companies have much leeway in the procurement process. Government agencies, however, spending public funds, must comply with laws, rules, and regulations governing each step in the procurement process.
The project manager facilitates creating a plan for how the procurement process proceeds. Deciding the correct type of contract is an important step in the procurement management process. There are three categories or flavors of contracts:
- Fixed Price (FP) (a.k.a. Firm Fixed Price (FFP)
- Cost-reimbursable (CR)
- Time and Material (T&M)
It is important for project managers to familiarize themselves with each of these major procurement contract types.
This article discusses the procurement process and the three main categories of contracts.
Project managers should know how to help create, read, and manage project related contracts. Contracts are typically written (verbal is quite rare these days) There normally is an exchange of goods or services for monetary or other compensation. The contract forms the legal relationship between the buyer and seller. It is mutually binding and explains how to proceed when one party fails to meet their obligations.
A contract is an agreement, but agreements are not necessarily contracts. Agreements may express and outline the intentions of the project. Note, in particular, that the project charter is an agreement, and not a contract. Agreements are less formal, whereas communication of contracts is always dictated in formal communication.
There are numerous types of project contracts, but three general categories: fixed price, cost reimbursable, and time & material. It is important to understand the contract types and be able to recognize the differences between them. And you must know how to select the most appropriate contract type depending on the project situation. Let’s examine the three main contract categories.
Fixed Price Contract
A contractor agrees to supply a product or service for a fixed price regardless of actual labor, material, and equipment costs. If cost become more than the agreed upon amount the contractor bears the additional costs. The buyer has the least cost risk, because the scope is well-defined. A clearly defined scope of work complemented by competitive bidders helps control pricing. Sellers base their bids on the procurement statement of work (SOW).
The fixed price contract is the buyer’s preferred contract type. Unfortunately, it is not always suitable for the project at hand. The buyer may not have enough intimate knowledge of the work required to prepare a comprehensive SOW.
Note that fixed price contracts may turn sour if the SOW is not well-defined; disagreement, disputes, and even lawsuits over what the SOW specifically says increase the risk of fixed price contracts. Fixed price contracts may also be more difficult for the seller, who may not have enough historical data to provide and accurate cost estimate.
A common mistake is for buyers to ask for a fixed price when the scope of work is incomplete. The consequences of a poorly defined SOW are the following:
- The seller takes on an untenable risk.
- The seller pads their estimate to reduce risk.
- The seller may try to increase profit by cutting scope or claim that buyer requested work is outside of scope.
- Porential sellers/cpntractors may ‘no bid’ the contract if the SOW is too poorly defined as this represents huge risk.
Implement a cost-reimbursable contract when scope is uncertain, and, accurate cost estimates are not possible. This precludes the fixed price contract. In a cost-reimbursable contract the buyer pays the workers for allowable incurred cost prescribed in the contract.
Cost-reimbursable contracts are typically implemented for software projects where the scope of work is difficult to define and keep from changing. In software projects the buyer often does not know what they really want until the seller demonstrates the deliverable. This places the seller in the precarious position of having to know what the buyer wants without clear direction.
Again, the cost reimbursable contract is suitable when scope is constantly changing or is not well-defined. These contracts are sometime called ‘Cost-plus-fixed-fee’, another type of cost-reimbursable contract where the prenegotiated fee is fixed at contract start.The fixed fee does not vary with the actual cost but can be adjusted when changes to the SOW are required.
Time and Material
When the level of effort is uncertain it is best to use a time and material contract. This contract may also be titled Unit Price. The buyer pays on a per-hour or per-item basis. So the hourly rate or unit price is known and fixed, but the quantity and, therefore, level of effort at the time of contract award is unknown. So the time and material contract is similar to a fixed price contract, as the per-hour or per-item basis is fixed. It also resembles a cost-reimbursable contract, because materials are reimbursed and the total cost is unknown.
The time and material contract does not factor in worker productivity, so workers have little incentive to be efficient. The seller’s profit is included in the hourly rate, and not the completion of the project. Again, the seller has no incentive to work quickly. Therefore, time and material contracts are better suited to small dollar amount projects of short duration.
So the fixed price contract is the buyer’s preferred contract type. In most situations this type of contract provides the buyer the least risk. It does, however, require a clearly defined scope of work. If the scope is not well-defined or even evolving, then the cost reimbursable contract would be the better route. Cost reimbursable is a common type of contract for software projects where scope is not fixed.
In fact, the nature of software project’s to be always changing requirements or scope is such an issue that a whole new project management paradigm resulted, known as agile. The blog at the following link provides A Brief Introduction to Agile Management of Software Projects.
In situations where the product is well defined, but effort to produce that product is unknown or variable, then the time and materials contract is favored. Worker productivity can be an issue in time and materials contracts, so it is better they be short duration and small priced projects. This way the buyer can keep a tight rein on their time and materials contract.
For a more in-depth look at procurement management, refer to Rita Mulchay’s book PMP Exam Prep, Eighth Edtion.