3 Different Types of Contracts: Procurement (PMP Exam)

There are three different types of contacts in procurement management. These are:

  1. Fixed Price (FP) – also called as Fixed Fee or Lump Sum
  2. Time & Material (T&M) – also called as Unit Price or Rate Contract
  3. Cost Reimbursable (CR) – also called as Cost Plus

In this article, you will find definition and explanation of the above contract types with the help of a few examples.

Note: The PMBOK® Guide describes the above Contract Types in the Procurement Management Knowledge Area. You can expect a few questions from this topic in the PMP Exam.

Types of Contract in Procurement Management

A contract is an 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 Seller is legally binding on both of them.

Note: You can refer to Max Wideman Glossary to read some other standard definitions.

Typically, an agreement document is very detailed and contains many things. It includes things like scope of procurement, legal jurisdiction, quality requirements, period of agreement etc. Among the other things, it also contains payment consideration.

An agreement can be divided into three broad types based upon the payment consideration viz. Fixed Price, Time and Material, and Cost Reimbursable.

In the next section, you will find a formal explanation of these types. Later in the article, you will find an easy example for understanding these types.

If you want, you can start with the example before looking at formal explanation.

Fixed Price Contracts

In Fixed Price Contracts, a Fixed Amount of consideration is required to be paid by the Buyer to the Seller for the Specified Work. The Specified Work could be Deliverables, a Service or a Result or anything else as defined in the agreement document. It is also called Lump-sum Contract.

Contract AttributeBuyer's ResponsibilitySeller's Responsibility
Scope of Work is well defined.Buyer has a legal obligation to accept finished work as defined in the Scope.Seller has a legal obligation to complete work as defined in the Scope.
Scope change (modification) is allowed as per the T&C of the contract.Generally, Buyer has to pay extra (over & above the Fixed Price) for the agreed upon change.Seller has to complete extra work as defined in the agreed upon change.
Price is Fixed.Buyer has a legal obligation to pay Fixed Price to the Seller after the work has been completed.Seller can legally claim full payment after completing the work as defined in Scope.
Cost Risk is in favor of the Buyer.Buyer has minimal Cost Risk.Seller has a Risk of losing money. Conversely the Seller can maximize her/his profits.
When is this used?Buyer can document Scope of Work in detail.Seller can estimate Cost based on the defined Scope of Work.

FP Contracts could run into losses for the Seller if the cost is not managed well and that’s why they are more risky for the Sellers. You can read my other article to understand why FP agreements are more risky for the Sellers.

Example projects where this is generally used:

  1. for developing limited scope software projects like developing mobile apps.
  2. for testing strength of telecom signals in a region.

There are three sub-categories of this type of contract:

  1. Firm Fixed Price (FFP)
  2. Fixed Price Incentive Fee (FPIF)
  3. Fixed Price with Economic Price Adjustments (FP-EPA)

Time & Material Contracts

In Time & Material Contracts, a Fixed Rate is required to be paid by the Buyer to the Seller for the Specified Unit. The Specified Unit could be Labor Duration Unit or a Material Unit as mutually decided between the Buyer and the Seller. The Quantity of Labor or Material is not specified at the beginning. The Quantity is take as per the actual consumption.

T&M is a hybrid of the FP and CR Contract Types. It resembles FP as there is a Fixed Rate. It resembles CR as Quantity is not specified. It is also called Rate Contract or Unit Price Contract.

General AttributeBuyer's ResponsibilitySeller's Responsibility
Scope of Work is broadly defined. Quantity is undefined.Buyer provides acceptance only after work is satisfactorily completed.Seller has a legal obligation to complete the work as defined by the Buyer.
Scope change (modification) is allowed as per the T&C of the contract.Buyer has a legal obligation to pay for the extra units that were used due to changes.Seller can legally claim payment for the extra units that were used due to changes.
Rate is fixed.Buyer has a legal obligation to make payment for each unit delivered by the Seller at the predefined rate.Seller can legally claim payments at predefined rate after delivering the units.
Buyer and Seller share the Cost Risk.Buyer has to pay predefined rate for each delivered unit even if the work is not completed.Seller can claim only predefined rate for each delivered unit even if the costs escalate.
When is this used?Buyer is unable to estimate the quantity due to uncertainty of requirements or for some other reason.Seller cannot estimate the total cost due to the absence of well defined Scope of Work.

In T&M Contracts, both Buyer and Seller can overrun their estimated cost targets and that’s why they share the risk. You can read my other article to understand why Buyer and Seller share the risk in T&M agreement.

Example projects where this is generally used:

  1. for providing services of skilled/unskilled labor at a predefined rate e.g. services of lab technicians.
  2. for delivering standard off-the-shelf consumable products at a predefined rate like machine parts.

Cost Reimbursable Contracts

In Cost Reimbursable Contracts, the Buyer is required to reimburse Actual Cost of Work and an Agreed Upon Fee to the Seller for the Specified Work. The Specified Work is usually loosely defined in the agreement document. It is also called Cost Plus Contract.

Contract AttributeBuyer's ResponsibilitySeller's Responsibility
Scope of Work is either undefined or loosely defined.Buyer provides acceptance only after work is satisfactorily completed.Seller has a legal obligation to complete the work as defined by the Buyer.
Scope change (modification) is allowed as per the T&C of the contract.Buyer has a legal obligation to reimburse extra cost and additional fee that arises because of changes.Seller can legally claim extra cost and additional fee that arises because of changes.
Price is not fixed.Buyer has a legal obligation to reimburse the Actual Cost and agreed upon fee to the Seller.Seller can legally claim reimbursement of the Actual Cost and agreed upon fee after delivering the best effort.
Contract Fee is well defined.Buyer has a legal obligation to pay the agreed upon Fee to the Seller.Seller can legally claim Fee after delivering the best effort.
Cost Risk is in favor of the Seller.Buyer has maximum Cost Risk.Seller has almost no Risk of losing money.
When is this used?Buyer is unable to define Scope of Work due to lack of information or for some other reason.Seller cannot estimate Cost due to absence of well defined Scope of Work and changing economic conditions.

CR Contracts can escalate the cost of the Buyer if it is not managed well and that’s why they are more risky for the Buyers. You can read my other article to understand why CR agreements are more risky for the Buyer.

Example projects where this is generally used:

  1. large infrastructure projects where cost of goods changes from time to time e.g. cost of cement bags.
  2. projects involving lot of travel by project personnel.

There are three sub-categories of this type of contract:

  1. Cost Plus Fixed Fee (CPFF)
  2. Cost Plus Percentage Fee (CPPF)
  3. Cost Plus Incentive Fee (CPIF)
  4. Cost Plus Award Fee (CPAF)

Procurement Example for Understanding Contract Types

Let us understand these Contracts 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:

  1. Human Resource (HR) Cost i.e. Labor Cost
  2. Material Cost which includes 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.

To prepare the Quotation, the Contractor would start by estimating the cost i.e. the expenses that Contractor is likely to incur. The Contractor would consider aforementioned costs components (HR & Material Costs) to arrive at an estimate.

There could be three different scenarios for arriving at an estimate. These scenarios would depend upon:

  1. how much information we (as a buyer) have shared with the Electrical Contractor?
  2. what are the current market (economic) conditions?

The Contractor would choose one of the possible scenarios to arrive at an estimate and give us a quotation based on that. Let us take a look at these these scenarios in detail to 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.

Essentially, we have finalized everything before the Contractor walked in. We prepared a detailed Statement of Work (SoW) for the Contractor. The contractor would study the detailed Statement of Work (finalized designs and material specifications) to provide a Fixed Price Quotation.

  1. 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.
  2. 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 Labor and Material Costs. 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.

Scenario II – Time & Material

This scenario would come if detailed Electrical layout & design is not available with us. If that is the case, we will not be able to provide a detailed SoW to the Contractor. In the absence of a Sow, the Contractor will not be able to determine a reasonable estimate of the cost.

  1. 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).
  2. 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 & Material Rates for re-wiring the house. The Contractor would provide top-up Rates to us as a Fixed 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 Rate to the Contractor for completing the work. The actual quantity of Labor and Material consumed (for making final payments) will be determined only after the work is finished.

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. If that is the case, we will not be able to provide a detailed SoW to the Contractor. In the absence of a Sow, the Contractor will not be able to determine a reasonable estimate of the cost.

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. If such conditions persist then the Contractor cannot reasonably estimate 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. Instead, we will have to Reimburse all legitimate Costs and give a (Agreed upon) Suitable Fee to the Contractor.

Over to You

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.

Which contract types have you used in your organization? And, in your personal life? Which type of contact is best suited for your organization and why?

I would love to hear from you.

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