Types of Contracts and Risk
You are working for a Defense Contractor. Your company is bidding for a Government’s secret project called Project “Hush-Hush”. The Government has decided to outsource this project as a Fixed Price Contract. Who has more Risk for this Project?
- Defense Contractor
- All Projects are risky. Both Defense Contractor and Government take equal Risk.
- It is a secretive project. The information provided is insufficient. It cannot be determined who has more Risk.
PMP® Exam may have 1-2 such questions. These questions combine two concepts – Types of Contracts and Risk. Specifically the questions probe which Types of Contracts are more Risky than the others. Let us try to answer the above question.
Procurement Management and Risk Management
A typical PMP® question (like the one above) would present a project or procurement scenario. The scenario would provide some details about the Project/Contract. The question would then ask who has more Risk in the given situation – the Buyer or the Seller? You will have to first understand which Type of Contract is being described in the situation and then answer the question.
The definition and explanation of Types of Contracts is part of Procurement Management Knowledge Area of the PMBOK® Guide. PMBOK® Guide talks about Three Types of Contracts. The Three basic Types of Contracts are further divided into few sub-types.
1. Fixed Price (FP)
- Firm Fixed Price (FPP)
- Fixed Price Incentive Fee (FPIF)
- Fixed Price with Economic Price Adjustments (FP-EPA)
2. Cost Plus (CP) or Cost Reimbursable (CR)
- Cost Plus Fixed Fee (CPFF)
- Cost Plus Incentive Fee (CPIF)
- Cost Plus Award Fee (CPAF)
3. Time and Material (T&M)
There is no sub-type in T&M contract type.
Note: You might find different nomenclature in PMP® reference books but for the sake of standardization, I am using the terms from the PMBOK® Guide.
I have discussed different Types of Contracts and their sub-types in a separate post. I will not describe the different Types of Contracts here. In this post, I am concentrating on what is the degree of Risk in different Types of Contracts. Let us answer which Type of Contract is more Risky than the other. Let us first answer the following Q:
What does Project Risk signify?
Project Risk entails uncertainty. A Project Risk may or may not occur. A risk is said to be high if uncertainty (probability of occurrence) is large. On the other hand a Risk is said to be low if uncertainty (probability of occurrence) is small. Simply speaking higher the uncertainty, higher the Risk.
Who is taking the the Project Risk – “Buyer” or the “Seller”?
A Risk that is high for the Buyer will be low for the Seller and vice versa. You should properly understand the context of the question before answering it. You should check if the question is asking about the Risk for the Buyer or the Risk for the Seller.
What is the Impact of the Project Risk?
All Risks entail some Impact. It means that a Risk will impact at least one of the project objectives. Generally speaking project objectives can be defined in terms of Time, Scope, Quality or Cost. Usually the PMP® question does not mention anything about the project objective or the type of impact. The question just asks “Which Type of Contract is more risky?”. If the PMP® question does not mention anything then you should assume that the question is asking about the Cost Risk. Typically the question would ask who (Buyer or Seller) is taking higher Risk if a particular Type of Contract is signed.
The Final Answer
Let us find out who would have least/maximum Cost Risk in different Types of Contracts. Following diagram will give you an overall picture.
In the above diagram the direction of arrows signifies increase in Risk. Let us discuss different Types of Contracts in the context of above diagram.
1. Fixed Price (FP)
At the start of the Contract, the Buyer knows how much payment has to be made to the Seller. Buyer liability is Fixed. Hence, we can say that the Buyer has very low Cost Uncertainty.
At the start of the Contract, the Seller does not about about the quantum of profit. The Seller may lose money. The Seller makes Profit if work is completed within the funds provided by the Buyer. Otherwise the Seller makes a loss. Hence, we can say that the Seller has high Uncertainty for making Profit.
Risk is low for the Buyer while it is high for the Seller.
2. Cost Plus (CP)
At the start of the Contract, the Buyer does not know how much payment will be made to the Seller. Buyer has potentially unlimited liability in a pure CP Contract. Hence, we can say that the Buyer has a very high Cost Uncertainty.
At the start of the Contract, the Seller knows that the Buyer will reimburse all legitimate costs. In addition the Seller will also get agreed Fees. The Seller likely to make always make some profit in a pure CP Contracts. Hence, we can say that the Seller has a low Uncertainty for making Profit.
Risk is low for the Seller while it is high for the Buyer.
3. Time & Material (T&M)
T&M is middling Type of Contract. It is hybrid of FP and CP. T&M Type of Contracts are based on a Fixed Rate. This Fixed rate is applicable for both the Buyer and the Seller. The Buyer and the Seller share the uncertainty in T&M Contracts.
At the start of the Contract, the Buyer does not know for how long will the Contract run or how much material/resources will be required to complete the Contract. The Buyer’s cost might escalate due to these unknowns. Hence, we can say that the Buyer has some degree of Cost Uncertainty.
At the start of the Contract, the Seller does not know how the Cost of labor or material will vary over the life-cycle of the Contract. The Cost of labor or material may increase over the life-cycle of the Contract. This might decrease the profit per unit of the Seller. The Seller may even lose money if the Costs goes up substantially. Hence, we can say that the Seller has some degree of Cost Uncertainty.
Both the Buyer and the Seller share the Risk.
Can you find out who would bear more/less risk for each sub-type? Please leave a comment. Let us discuss further.