Mathematical Orientation of Contract Types
Procurement Management Knowledge Area of PMBOK® Guide defines 3 different Contract Types. I have already written two articles to explain these Contract Types.
I have written this article to provide a completely different perspective to the Contract Types. This article discusses mathematics and formulas behind different Contract Types. The article also defines some of the basic terms used in Procurement Management.
Let us first discuss some basic definitions of Procurement Management.
The total amount of money that is paid or promised to be paid by the Buyer to the Seller.
Deemed, Estimated or Actual Expenditure incurred by the Performing Organization (usually spoken in the context of the Seller).
Profit, reward or compensation earned or deemed to be earned by the Seller.
The amount of money per Unit that is paid or promised to be paid by the Buyer to the Seller.
You can also refer to Max Wideman Glossary to read some other definitions of these terms.
Formulas Behind Different Contract Types
Let us discus the mathematical Equations of different Contract Types (as defined in PMBOK Guide®) using the above definitions.
Fixed Price Contracts
Price = Cost + Fee
- The Buyer and the Seller agree upon a Price at the time of signing the Contract.
- The buyer knows only about the Price at the time of signing the Contract.
- The Seller estimates Cost and Fee and proposes a Price to the Buyer before signing the Contract. The Buyer, usually, does not have any knowledge about Cost and Fee.
- The Sellers have more Cost Risk than the Buyers in this type of Contract.
Cost Plus Contracts
Price = Cost + Fee
- Neither Price nor Cost is agreed between the Buyer and the Seller at the time of signing the Contract.
- Neither the Buyer nor the Seller have any knowledge about the Price or Cost at the time of signing the Contract although there could be some estimates.
- The Buyer and the Seller usually agree upon the Fee or a criteria for determining the Fee at the time of signing the Contract.
- The Cost is determined on the basis of Actual Expenditure by the Seller.
- The Buyers have more Cost Risk than the Sellers in this type of Contract.
Time & Material Contracts
Price = Rate * Quantity
Rate = Cost per unit + Fee per unit
- The Buyer and the Seller agree upon a Rate at the time of signing the Contract.
- Neither the Buyer nor the Seller have any knowledge about the Quantity at the time of signing the Contract.
- The Seller estimates Cost per unit and Fee per unit and proposes a Rate to the Buyer before signing the Contract. The Buyer, usually, does not have any knowledge about Cost per unit and Fee per unit.
- The Buyers and Sellers share Cost Risk in this type of Contract.
Over To You
I have not seen any book or guide that explains or even lists these formulas. I believe these are more of generic equations rather than formulas but it helps to express something mathematically. What is your opinion about them? Were you able to understand them? Do you think a mathematical expression is helpful for understanding. Please leave a comment.
PMP Exam Formulas
I have also compiled a PMP Formulas Cheat Sheet. It will help you in your exam prep. You can read more about it and directly download it free by joining PMP prep linkedin group. It is the best and most comprehensive cheat sheet based on the PMBOK Guide 6th.
If you are looking beyond a cheat sheet, then I would suggest you to buy detailed PMP Exam Formula Study Guide by Cornelius Fichtner. It contains detailed explanations of all the formulas along with examples and 105 practice questions.
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