Understanding Different Contract Modalities

Contracts can be configured in various ways, but most are divided into one of two categories: fixed price contracts (also called lump sum contracts) and cost plus contracts (also called cost reimbursable contracts). Following is a summary differentiating the characteristics of these two contract modes:

Fixed price contracts. Sellers agree to provide well-defined goods and/or services by a specific date at a fixed price. Sellers bear most of the risk on this contract, because if there is a cost overrun, the seller must assume the burden of the loss. Fixed price contracts also have “opportunities,” because if the seller’s costs are very low, they have an opportunity to increase their profits.

Cost plus contracts. Buyers agree to reimburse sellers for whatever costs they incur in carrying out the contracted work. Clearly, buyers face a serious risk of cost overruns here, because if contractors spend too much, buyers are obliged to reimburse them. In order to create incentives for buyers to save money, some variations on cost plus contracts have emerged, including:

cost plus incentive fee contracts (CPIF). With the CPIF contract, a table is created that shows how contractors can be paid defined bonuses if they deliver their products early (e.g., $5,000 bonus if delivered one week early; $8,000 bonus if delivered 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. If contractors do a great job on their contracts, an award fee panel may elect to pay 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., profit amount) that the buyer will pay the contractor, given that work is completed in a satisfactory manner. The fee is negotiated before any work has begun. Thus contractors know ahead of time what their profit levels will be. They have no incentive to increase costs in hopes that that will lead to higher profit levels. CPFF contracts are the dominant contract mode for research and development projects, which are high risks efforts.

A commonly employed variant of the cost plus contract is the time and materials contract. This is a cost reimbursable contract where contractors are reimbursed for the time they put into a job plus expenses they incur in purchasing materials. Unlike the cost plus contracts, there is no explicit “plus” associated with the contract. This does not mean profits cannot be gained. If profits are factored into this type of contract, they must be built into the salaries and material costs associated with performing the contract.

Assignment

For the following types of undertakings, which contract modes are most appropriate?Be prepared to explain the rationale behind your choice.

We want to order a pencil manufacturer to produce 20,000 pencils for us

We want to have a 300 meter bridge built to span a local river

We want to have a contractor design a brand new circuit board that has state-of-the-art capabilities

We want to contract out work to operate our small factory

Describe the relative benefits and weaknesses of a CPIF contract vs. a CPAF contract.