Types of contract?
There are several types of contracts typically used to engage software development vendors /suppliers:-
Firm Fixed Price
A firm fixed price (FFP) contract is used most often. Another name for this contract is lump sum. This type of contract, the supplier agrees to furnish supplies or services at a specified price that is not subject to adjustment because of performance costs. This type of contract is best suited when reasonably definite production specifications are available and costs are relatively certain. The seller bears the greatest degree of risk in this contract type and may therefore pad their price for contingencies that may occur during the project. In this situation, the seller is motivated to decrease costs by producing efficiently because regardless of what that costs are, the seller receives the agreed upon amount. As a consequence, the seller should place emphasis on controlling costs.
Fixed Price Incentive
A fixed-price incentive (FPI) contract is composed of a target cost, target profit, target price, ceiling price, and share ratio. This contract type is probably the most complex.
Example: Based on a ceiling price of £120,000, a target cost of £100,000, target profit of £10,000, a target price of £100,000, and a share ratio of 70/30, for every dollar the seller can reduce costs below £100,000 the savings will be shared by the buyer and seller based on the negotiated sharing formula, which reflects the degree of uncertainty faced by each party. Assuming the seller tries to maximise profits, this provides an incentive to reduce its costs and deliver more efficiently.
When a ceiling price is agreed to up front, the seller assumes all overruns above the ceiling; bit if costs exceed the target cost of £100,000 regardless of the costs incurred by the seller, both the buyer and seller share the risk up to the ceiling. This incentive-type contract is usually used when contracts are for substantial sums and involve a long production time. This enables the seller to develop production efficiencies during the performance of the contract.
Cost Plus Incentive Fee
A cost plus incentive fee (CPIF) is a cost-reimbursement contract. The CPIF means the seller is paid for allowable performance costs along with a predetermined fee and an incentive bonus. If the final cost is less than the expected cost, both the buyer and seller benefit by the cost savings based on a prenegotiated sharing formula. This sharing formula is an agreed-upon percentage reflecting the degree of uncertainty each party will bear.
Example: Say that the expected cost is £100,000, the fee to the seller is £10,000, and there is a sharing formula of 85/15. Under this contract, the buyer absorbs 85% of the uncertainty, and the seller absorbs 15% of the risk. If the final price is £80,000, resulting in a cost savings of £20,000, the seller’s compensation includes the final cost and the fee, plus an incentive of £3,000 (15%of £20,000), for a total reimbursement of £93,000.
Cost plus Fixed Fee
A cost plus fixed fee (CPFF) contract provides that the seller be reimbursed for allowable costs of performing the contract, and in addition the seller receives as profit a fee payment, usually based on a percentage of estimated costs. This fixed fee does not vary with actual costs unless the scope of work is changed.
Example: if the estimated cost for a project is £500,000, to be completed in six months. The project was completed five weeks early and 10% under budget. With this type of contract the buyer has agreed that if the project comes in early and under budget, an award would be formulated as follows:
Base award = 2% of the original budget, or £10,000
Cost award = £10,000 for every 5% under budget. In this case the cost award is £20,000.
Schedule award = £5,000 for every week the project comes in early from the original time estimate. In this case the schedule award is £25,000.
Total Award is £55,000.
Time & Materials T&M
Time and Materials (T&M) contracts have fixed-unit arrangements but are open –ended. The PMBOK guide, 4th ed., p.34, describes time and material contracts as a “hybrid type of contractual arrangement that contains aspects of both cost-reimbursable and fixed-price arrangement.”
T&M contracts resemble cost-type arrangements in that they are open-ended, because the full value of the arrangement is not defined at the time of the award. Thus T&M contracts can grow in contract value as if they were cost-reimbursable arrangements.
Conversely, T&M arrangements can also resemble fixed-unit arrangements, when, for example, the unit rates are preset by the buyer and seller, as when both parties agree on the rates for a specialty resource (for example, senior engineer). This contract type is often used for staff augmentation agreements rather than project completion contracts.
Cost plus percentage of cost
A cost plus percentage of cost (CPPC) contract provides for reimbursement to the supplier for allowable costs of contract performance. Additionally, the contractor receives an agreed –upon percentage of the estimated cost as profit.
Example: If the estimated cost is £100,000 and the agreed-upon percentage is 10%, the estimated total price is £110,000. If the seller increases costs to £110,000, the total price would be £121,000, which will result in an increase in profit of £1,100.
If you come across any other types of contract in the course of business please comment below. We receive lots of mail on this subject and any expansion on this list would help our readers.
Copyright @ Clarety Consulting 2009
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