CONTRACT PAYMENT TYPES
The matter of when the contractor is to be paid, and how much, must be clearly described in the contract document; whether you use a Purchase Order or a more lengthy contract. Payment to the Contractor falls into one of 3 broad types. They are: Fixed Price; Cost Reimbursable; and Time and Material. Each type has categories, described below. For every contract type and category there exists varying degrees of risk to the buyer, risk to the seller, incentives for meeting schedule, and predictability of final cost. Depending upon the contract duration, payment might be made all at once or as the work progresses, so these contract types and categories have nothing to do with payment timing.
FIRM FIXED PRICE
This is the simplest type of contract. The full price is agreed before purchase is made. It is most suitable when the deliverable can be clearly defined. Think of going to the store to buy something off the shelf. What you are buying is clearly defined and you are certain what it will cost. There is almost no risk the buyer, but the store has the risk of trying to make a profit from that item. This type of contract is suitable for short term, non-complex projects with a clearly defined scope.
When the scope cannot be clearly defined, sellers are reluctant to provide fixed prices for fear of losing money. In these cases a cost reimbursable contract assures the seller that the buyer will pay for their costs, thereby reducing the risk to the seller but increasing the risk to the buyer. But the seller wants to do better than just recovering cost. The seller also wants to make a profit. For this reason cost reimbursable is often called "cost plus". There are at least 3 categories of cost reimbursable contract to deal with seller profit.
TIME and MATERIAL
This type of contract (T&M) states the buyer will pay for all labour and material at pre-agreed rates regardless of how much time and how much material the seller uses. If the scope cannot be defined at all (think of an emergency situation) this type of contract can be quickly agreed and put into action. The seller has no risk as they will get paid at their set rate (which will include profit) for whatever they do. The buyer has all the risk (think blank cheque!). However, a T&M contract can have a Ceiling (not to exceed) price. On occasion, a T&M contract can used for a quick start, then the contract converted to a type and category less risky to the Buyer.
FIXED UNIT PRICE
This is a variation on Firm Fixed Price. It is useful when the scope can be clearly defined, but the quantity is not yet known. For example, a restaurant needs specific tables and chairs in the contract but will not know the exact quantity until later. The unit price contract sets the firm price for each table and each chair. The Actual amount to be paid will only depend upon the number of each.
Clearly there is no ideal contract type and each type has advantages and disadvantages. To modify the advantages and disadvantages, a number of categories have been developed. Each of these categories can be applied to either a fixed price type, or cost reimbursable type. Remember, the contract type and category is determined before the request for bid or for proposal goes on the market. These modifying categories are:
a) with a fixed fee. The profit (fee) paid to the seller is fixed
b) with an economic price adjustment. A fee is paid to allow for inflation
for long running contracts.
c) with an incentive fee. An incentive (bonus) is paid to the
seller for doing better than a target; such as spending less than a
d) with a percentage fee. The profit (fee) paid to the seller is a percentage
of the actual amount the contractor spends.
e) with an award fee. A fee is paid to the seller based on the buyers
satisfaction of the deliverable.
Putting contract types together with modifying categories, the most common types of contracts (not in any order) are:
Firm Fixed Price (no modifier)
Fixed Price with Economic Price Adjustment (FP withEPA)
Fixed Price with Incentive Fee (FPIF)
Cost Plus with Fixed Fee (CPFF)
Cost Plus with Percentage Fee (CPPF)
Cost Plus with Award fee (CPAF)
Cost Plus with Incentive Fee (CPIF)
This is not an exhaustive list as any type and category can be created and used, as long as it is agreed by both parties. To see the advantages and disadvantages (Pros and Cons) of contract types and categories, just........
1. Fee always means profit
2. Split is always Buyer / Seller
3. Risk always reduces with Scope clarity, and increases with Scope vagueness
4. Lack of Scope clarity requires a less restrictive contract type and category
5. In a cost saving, FPIF and CPIF always have the same results
6. CPFF is always a good deal for the Seller
7. CPPF is always a bad deal for the Buyer
8. Only in Incentive and Award Categories is the Seller motivated to perform.
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