Types of Contracts in Project Management – PMP Exam

Often, professionals preparing for the PMP Exam encounter confusion due to the complexity of various contract types. To simplify, there are three primary contract types: Fixed Price, Time and Materials, and Cost Reimbursable (also known as Cost Plus). Sometimes, these contract types have variants that incorporate incentives and awards. This article will focus on understanding these three core contract types.

Key Procurement Terminology

Before diving in, let’s establish a shared understanding of a few crucial terms and contexts:

Context: Within the scope of the PMP exam, procurement is discussed in the scenario where you, as a Project Manager, decide to outsource certain parts of your project scope, or when you need external resources (physical or human). In this scenario, you function as a buyer, entering into a contractual agreement with a seller.

Procurement Strategy: To carry out procurement successfully, you should devise a strategy that aligns with your organization’s procurement policies. The strategy should define the contract types to be used in your project and identify which tasks require which type of contract.

Contract: A contract is a legally binding agreement made with a supplier or seller who will execute the outsourced tasks. Your organization agrees to pay them for this service. The type of contract, which is the main topic of this article, governs how payments are processed and how you collaborate with the supplier/vendor/seller.

Supplier/Vendor/Seller/ Contractor: This entity completes your outsourced tasks. They may do so through a specific project or by delivering pre-made products or services.

Type of Contracts

There are three different contract types that is widely adopted in the industry. These include:

• Fixed Price Contracts (FP)
• Cost Reimbursable Contracts (CR)
• Time & Material Contracts (T&M)

Fixed Price Contracts (FP)

A fixed-price contract is a type of contract where the contractor/ supplier actor agrees to complete the project or deliver the service for a specific sum. This type of contract can be beneficial when the scope and schedule of a project are clear. It provides certainty for both the buyer and the supplier, as they both know the exact price to be paid for the completed work.

There are a few variations of fixed-price contracts, including:

Firm Fixed-Price Contracts (FFP): This is the most basic form where the supplier/contractor agrees to perform the work for a set price. The risk falls on the contractor if the actual cost exceeds the agreed-upon price.

Fixed-Price Incentive Fee Contracts (FPIF): This type has a mechanism that can adjust the profit and establish a final contract price using a formula based on the contractor’s performance. If the contractor completes the project under the estimated cost, they share the savings with the buyer.

Fixed-Price with Economic Price Adjustment Contracts (FP-EPA): This contract provides a special provision where certain predefined conditions allow for adjustments to the contract price. It’s often used in long-term contracts where inflation might impact costs.

Drawback of Fixed – Price Contract

The main drawback of fixed-price contracts is that they can lead to poor quality outcomes if the supplier finds the work is more complex or time-consuming than anticipated, and they attempt to cut corners to remain within budget. It’s also common to see suppliers including contingencies in their price, which may make the contract more expensive upfront. In addition, if the project requirements are not well defined from the beginning, it can lead to disputes and additional costs for changes.

Largely used when

• There is high level of clarity on scope of project
• Fair amount of clarity on the type of work and the process required to achieve the project results
• Limited variability in project or high level of predictability
• Heavy focus on accomplishing something within a predetermined cost
• Buyer wants to control the cost overrun

Examples of Fixed Price:

• Purchasing an Apartment: When you buy an apartment, the seller often sets a fixed price. Once you agree on the price and sign the contract, you are obliged to pay that amount, regardless of any other factors or costs incurred by the seller.
• Holiday Packages: Travel agencies frequently offer holiday packages at a fixed price. This price typically includes flights, hotels, and other services such as guided tours or meals. No matter what the actual costs are for the agency, you pay the fixed price agreed upon when you book the package.
• Off-the-Shelf Software Packages: When buying pre-packaged software, you pay a fixed price for the product. This price doesn’t change based on how much it cost the developer to make the software or how many hours they spent creating it.
• Construction of a Road: In this case, a government or organization might contract a construction company to build a road for a fixed price. The construction company estimates the total cost and agrees to complete the project for that price, regardless of the actual costs incurred during the construction process.

Cost Reimbursable Contracts (CR)

A cost-reimbursable contract, also known as a cost-plus contract, is a type of contract where the contractor is paid for all of its allowed expenses to a set limit plus additional payment to allow for a profit. The exact amount of the total cost is often unknown until the work is complete, although estimates can be provided.

This type of contract is typically used when it’s difficult to accurately estimate the total project cost at the time of contract award. This could be due to uncertainties in the project scope, the complexity of the project, or the length of the project.

There are several types of cost-reimbursable contracts, including:

Cost Plus Fixed Fee (CPFF): In this type of contract, the contractor is reimbursed for all allowed costs plus a fixed fee payment, usually stated as a percentage of the initial estimated project costs.

Cost Plus Incentive Fee (CPIF): The contractor is reimbursed for all allowed costs plus an incentive fee tied to achieving certain performance goals. The incentive fee may vary with the performance of the contractor.

Cost Plus Award Fee (CPAF): The contractor is reimbursed for all allowable costs plus an award fee based on the satisfaction of subjective performance criteria. The exact amount of the award fee is determined by the buyer’s satisfaction with the contractor’s performance.

Drawback of Cost-Reimbursable Contract

The primary risk of cost-reimbursable contracts for buyers is the lack of cost control, as the contractor has little incentive to control costs. Therefore, these contracts often include maximum cost clauses and other mechanisms to help control costs. These contracts require careful management and clear communication between all parties to ensure a successful outcome.

Largely used when:

• Limited clarity on scope
• High variability in projects
• Projects are abstract and are expected to evolve over the course of time
• Required specialized skills by the vendor/supplier.
• Focused on creating the value & experience for the customer rather than completing the project on budget

Examples of Cost Reimbursable

• Event Decor: This could be for creative or innovative projects where the exact costs can’t be predicted in advance. For example, when hiring an event organizer for a large gathering, the organizer might need to make various purchases such as decorations, lighting, audio equipment, and more. As the client, you would reimburse the organizer for these costs.
• Media Campaigns: Media campaigns often involve various unpredictable costs. For instance, creating a marketing campaign might require hiring a graphic designer, buying ad space, or paying for video production. These costs can vary greatly depending on the specific needs of the campaign and are typically reimbursed by the client.
• Research and Development Projects: In R&D projects, it’s often hard to estimate the total costs upfront due to the unpredictable nature of the work. Therefore, organizations often use cost-reimbursable contracts for these projects.

Time and Material

A Time and Materials (T&M) contract is a type of contract that is a hybrid of both fixed-price and cost-reimbursable contracts. In a T&M contract, the client agrees to pay the contractor based upon the time spent by the contractor’s employees and for materials purchased to complete the project, plus the contractor’s profit.

Here are the main components of a T&M contract:

Time: This is often billed on an hourly rate. The contractor tracks the time spent on the project and invoices the client accordingly.

Materials: These are the physical inputs needed for the project, which can include everything from office supplies to heavy machinery. The client reimburses the contractor for the cost of these materials.

Drawback of Time and Material Contract

The client bears the risk in a T&M contract because the total project cost is not capped. To mitigate this risk, some T&M contracts may include “not-to-exceed” clauses that set a maximum limit on the amount that can be invoiced.

Largely used when:

• Moderate level of certainty in the project
• Reasonable visibility towards effort and type of resources required
• Limited predictability of amount of resources required
• Moderate variability as the process, material, people required are predictable

Examples of Time and Material

• Customized Software Development: When a company needs a software solution tailored to its specific needs, it might hire a developer or a team on a Time and Material basis. The final cost of the project may depend on several uncertain factors, such as the complexity of the task or any changes in project requirements, making a Time and Material contract more suitable.
• Staff Augmentation: If a business needs to expand its team temporarily for a project, they might hire additional staff for a specific time period on a Time and Material contract basis. The company would pay for the time these temporary employees work, plus any related costs, like recruiting or training expenses.
• Consulting Services: Many consulting services use Time and Material contracts. Consultants often work with clients on complex projects where the time required for problem-solving or strategy development can vary widely. The consultant charges for their time and any expenses incurred during the engagement.

PMP Exam Tips Related to Contract Types

• Understand the Nature of Work: It’s essential to comprehend the specifics of the work before choosing a contract type. This understanding can make the contracting process more efficient and effective.
• Fixed Price Contracts: As a project manager on the buyer’s side, if a fixed price contract is chosen, your responsibility is to ensure that the scope of deliverables is clearly defined, and acceptance criteria are explicitly listed and verifiable at various project milestones.
• Provisions for Changes in Fixed Price Contracts: As the buyer’s project manager, ensure that provisions for changes and scope alterations are well understood within fixed price contracts.
• Cost-Reimbursable Contracts: For cost-reimbursable contracts, you, as the buyer’s project manager, need to establish a process to agree on various purchases made by the seller. It’s expected for you to remain involved throughout the contract’s delivery.
• Time and Material Contracts – Competency Review: In time and material contracts, as the buyer’s project manager, you should ensure the necessary competencies are well defined for the required roles. It’s your duty to review these competencies regularly and, if they’re found lacking, initiate a process to replace individuals as needed.
• Engagement in Time and Material Contracts: With time and material contracts, your engagement as the buyer’s project manager is most pronounced during contract execution. You are the decision-maker on how much more time and materials are needed, adjusting requirements as the project progresses.

Conclusion

In conclusion, understanding the various contract types – Fixed Price, Time and Materials, and Cost Reimbursable – and their respective applications and limitations, is crucial for project managers, especially for those preparing for the PMP Exam. The success of a project often hinges on the appropriate selection and management of these contracts.

While this article has provided a comprehensive overview of contract types and their usage, mastering these concepts can be complex. That’s where our Live PMP Sessions come in. These sessions provide in-depth explanations, real-world examples, and interactive discussions, designed to enhance your understanding of these crucial project management components.

Joining our Live PMP Sessions can significantly speed up your preparation process for the PMP Exam. You’ll gain direct access to experienced instructors who can clarify doubts, share their expertise, and provide personalized guidance. This interactive learning experience, coupled with the wealth of knowledge offered, can be a game-changer for your PMP Exam preparation.