Understanding Different Contract Modalities
Contractscan be configured in various ways, but most are divided into one of twocategories: fixed price contracts (also called lump sumcontracts) and cost plus contracts (also called cost reimbursablecontracts). Following is a summarydifferentiating the characteristics of these two contract modes:
Fixed price contracts. Sellers agree to provide well-defined goodsand/or services by a specific date at a fixed price. Sellers bear most of the risk on thiscontract, because if there is a cost overrun, the seller must assume the burdenof the loss. Fixed price contracts alsohave opportunities, because if the sellers costs are very low, they have anopportunity to increase their profits.
Cost plus contracts. Buyers agree to reimburse sellers forwhatever costs they incur in carrying out the contracted work. Clearly, buyers face a serious risk of costoverruns here, because if contractors spend too much, buyers are obliged toreimburse them. In order to createincentives for buyers to save money, some variations on cost plus contractshave emerged, including:
cost plus incentive fee contracts (CPIF). With the CPIF contract, a table is createdthat shows how contractors can be paid defined bonuses if they deliver theirproducts early (e.g., $5,000 bonus if delivered one week early; $8,000 bonus ifdelivered two weeks early).
cost plus award fee contracts (CPAF). With the CPAF contract, a pool of award fee money(i.e., a bonus pool) is created. Ifcontractors do a great job on their contracts, an award fee panel may elect topay them a bonus with money taken from the award fee pool of money. Judgments of performance are subjective.
cost plus fixed fee (CPFF). With CPFF contract, buyer and seller negotiate a fee (i.e., profitamount) that the buyer will pay the contractor, given that work is completed ina satisfactory manner. The fee isnegotiated before any work has begun. Thus contractors know ahead of time what their profit levels willbe. They have no incentive to increasecosts in hopes that that will lead to higher profit levels. CPFF contracts are the dominant contract modefor research and development projects, which are high risks efforts.
A commonly employed variant of the cost plus contract isthe time and materials contract. This is a cost reimbursable contract where contractors are reimbursedfor the time they put into a job plus expenses they incur in purchasingmaterials. Unlike the cost pluscontracts, there is no explicit plus associated with the contract. This does not mean profits cannot begained. If profits are factored intothis type of contract, they must be built into the salaries and material costsassociated with performing the contract.
Assignment
1. Forthe following types of undertakings, which contract modes are mostappropriate? Be prepared to explain therationale behind your choice.
Wewant to order a pencil manufacturer to produce 20,000 pencils for us
Wewant to have a 300 meter bridge built to span a local river
Wewant to have a contractor design a brand new circuit board that hasstate-of-the-art capabilities
Wewant to contract out work to operate our small factory
2. Describethe relative benefits and weaknesses of a CPIF contract vs. a CPAF contract.
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