There are three different types of contacts for managing procurement viz. Fixed Price, Time & Material, and Cost Plus. These are also called Fixed Fee or Lump Sum, Unit Price or Rate Contract, and Cost Reimbursable respectively.
I have written this article to explain these three contract types. After reading this article you will be able to understand the basic contract types with the help of a few examples.
Types of Contract in Procurement Management
What is a Contract?
A contract is a agreement between two entities, which is signed when one entity wants to purchase goods and/or services from another entity.
The entity on the buying side is called the Buyer or Customer and the other entity is called the Seller or Vendor. A contract between the Buyer and the Seller is legally binding on both of them.
Types and Sub-types of Contracts
A contract document is usually detailed and contains many things. It may include things like scope of procurement, legal jurisdiction, quality requirements, period of contract etc. One of the important aspects of a contract is payment consideration. Based on the payment consideration, a contract can be divided into three broad categories. These are:
- Fixed Price (FP) Contracts
- Time and Material (T&M) Contracts
- Cost Reimbursable (CR) Contracts
There are some sub-categories of these three types of contracts but we will stick to discussing the basic types. We will not discuss the sub-categories in this article.
Note: You can refer to Max Wideman Glossary to read some standard definitions on Types of Contract.
Procurement Example for Understanding Contract Types
Let us understand basic Types of Contract with the help of a small example.
Let us assume that we have to do a house renovation project. As part of renovation we need to rewire the whole house. There would be two broad cost components for the rewiring the house:
- Human Resource (HR) Cost e.g. Labor Cost
- Material Cost e.g. Wire Cost
Let us also assume that we (Buyer) have called an Electrical Contractor (Seller) to provide us with a Quotation for re-wiring the house.
Let us understand how a Contractor would prepare a Quotation.
The Contractor would start with an estimate of costs. The Contractor would consider aforementioned costs components (HR Costs & Material Cost) to arrive at an estimate. There could be three different scenarios for arriving at an Estimate. The Contractor can potentially choose one of the possible three scenarios to arrive at an Estimate. The three scenarios would depend on
- how much information we (as a buyer) have shared with the Electrical Contractor
- what are the market (economic) conditions.
Let us take a look at these 3 scenarios in detail and understand the three basic Contract types.
Scenario I – Fixed Price
Let us assume we called a Building Architect before calling the Electrical Contractor. The Architect provided us with complete Electrical Layout & Design. The Architect also gave us Material Specifications of the Wiring to be used. In brief we finalized everything before the Contractor walked in. We prepared a detailed Statement of Work for the Contractor. The contractor would study the detailed Statement of Work (finalized designs and material specifications) to provide a Fixed Cost Estimate.
- HR Cost – The contractor would look at the whole house and architectural design to estimate how many Labor units (duration & effort) would be required to complete the work.
- Material Cost – The contractor would survey the house and study the Electrical Layout & Design to make an approximation of how much Wire (quantity of wire) would be required.
Based on above two estimates, the Contractor can estimate Cost of Labor and Cost of Wire. The Contractor would total these Estimates and add some profit to provide us with a Fixed Price Quotation. This Quotation (once finalized and accepted by us) would become part of the Contract. We will have to pay a Fixed Price to the Contractor for completing the work. Even if the Contractor overruns his estimates, we would not be liable to pay anything extra.
Salient Features of FP Contracts
- In FP Contracts Scope is well defined and Price is Fixed.
- FP Contracts could run into losses for the Seller if the costs are not managed well. FP Contracts are more risky for Sellers.
Scenario II – Time & Material
This scenario would come if Electrical layout & design was not available with us. We will not be able to provide a detailed Statement of Work to the Contractor. The Contractor would have to prepare the Quotation without a detailed Statement of Work.
- HR Cost – Since the Electrical Layout & Design are not available, the Contractor would not be able to estimate how much Labor units (duration & effort) would be required to complete the work. The Contractor can, however, estimate the Labor Rate per Day (or any other unit of time e.g. hour or week).
- Material Cost – Again the Contractor would not be able to estimate the quantity of wire that would be required to complete the work. The Contractor can, however, estimate the Rate per Meter (or any other unit of quantity e.g. Kg) for different types of wires required.
The contractor would add a suitable margin to estimated Labor Rate & Wire Rate for re-wiring the house. The Contractor would provide top-up Rates to us as a Rate Quotation. These Rates (once finalized and accepted by us) would become part the Contract. These Rates will remain Fixed for the duration of the Contract. We will have to pay the Fixed Rate to the Contractor for completing the work. The actual quantity of Labor and Material consumed will be used for making final payments.
Salient Features of T&M Contracts
- In T&M Contracts Quantity is not defined and Rate is Fixed.
- In T&M Contracts both Buyer and Seller can overrun their estimated Cost targets. T&M Contracts are risky for both Buyers and Sellers.
Scenario III – Cost Reimbursable or Cost Plus
This scenario is similar to Scenario II above. This scenario would come if Electrical layout & design was not available with us. We will not be able to provide a detailed Statement of Work to the Contractor. The Contractor would have to prepare the Quotation without a detailed Statement of Work.
In addition, let us assume that Market (Economic) Conditions are constantly changing. There is a constant fluctuation of Labor Rates and Wire Rates in the market. In these conditions, the Contractor cannot reasonably estimate a Fixed Rates.
In this Scenario, the Contractor would propose (since Labor Rate & wire Rate cannot be fairly estimated) that the Actual Costs incurred by her/him should be Reimbursed. In addition, the Contractor, would ask for a Suitable Fee for the services that she/he would render to complete the work. This proposal (once finalized and accepted by us) would become part the Contract. Neither the Rates nor the Quantity would be Fixed for the duration of the Contract. A Service Level Agreement, however, can be defined as part of the Contract. We will have to Reimburse all legitimate Costs and give a Suitable (Agreed upon) Fee to the Contractor.
Salient Features of CP Contracts
- In CP Contracts neither the Rate nor the Quantity is defined.
- CP Contracts could be a huge overhead for the Buyer if costs are not managed well. CP Contracts are more risky for Buyers.
Procurement Management is considered to be a difficult aspect of project management but I think it is an easy topic as purchasing is part of our day to day life. No human being can live without purchasing something or the other.
Who has more Risk in different Types of Contract?
- Fixed Price – Seller has more Risk
- Time and Material – Buyer and Seller share Risk
- Cost Plus – Buyer has more Risk
You should read my other article on that provides a formal explanation of different Types of Contract. It will help you in the PMP® Exam preparation.
Please leave a comment if you have any specific question.