1. Fixed Price (Lump sum) Contracts:
The seller and the buyer agree on a fixed price for the project. The seller accepts the risk in this type of contracts. The buyer has less risk as the price is already fixed and there is an agreement on the same from seller side as well. There must be a clear, specific and detailed project scope.
Advantages of fixed price contracts include throwing all the risk on the seller. The main disadvantage is that the seller may start cutting scope or quality in order to finish on time and on budget.
There are three subtypes of fixed price contracts
- Fixed Price Incentive Fee (FPIF) – If project finished little bit earlier, an additional amount will be paid to the seller.
- Fixed Price Award Fee (FPAF) – If the performance of seller exceeds as planned earlier an additional amount will be paid to the seller.
- Fixed Price Economic Price Adjustment (FPEPA) – The fixed price can be re-determined depending on the market pricing rate.
2. Cost Reimbursable Contracts
What will you do if the scope of the work is not clear or not fully identified? You can’t use fixed price contracts. In cost reimbursable contracts, the seller will work for a fixed time period and after finishing the work he will raise the bill and the buyer will pay the amount after this. This is risky for the buyer. A seller can raise the unknown amount which the buyer has to pay. Seller is happy with this type as profit is almost guaranteed while the buyer finds it difficult to control budget.
There are a few kinds of cost reimbursable contracts:
- Cost Plus Fee (CPF) or Cost Plus Percentage of Costs (CPPC) – The seller will get the total cost they incurred on the projects plus a percentage of fee over cost (as a profit). Always beneficial for seller.
- Cost Plus Incentive Fee (CPIF) – A performance based extra amount will be paid to the seller plus actual cost they have incurred on the projects.
- Cost Plus Award Fee (CPAF) – The seller will get a bonus amount plus the actual cost incurred on the projects.
This graph shows the amount of risk that each of the seller and buyer has in different types of contracts
3. Time and Material Contracts or Unit Price Contracts:
The contract is based on unit price or hour (day) price. For example, if the seller works 2,000 hours for a project, and the agreed rate is $100 / hour, the buyer will pay the seller $200,000. This type of contracts is typical in outsourcing work. The advantage of this type of contract is that the seller will make profit for every hour spent on the project. The advantage for the buyer is to get resources to do the task under the buyer’s control without having long-term commitment with the resources. It’s also beneficial for having scarce resources. The disadvantage is that the buyer has the risk of exceeding budget.
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