8.7 Procurement & Contracts
Key Takeaways
- Fixed-Price contracts place maximum risk on the seller; the buyer knows the total cost upfront if scope is well-defined
- Cost-Reimbursable contracts place maximum risk on the buyer; seller is reimbursed for all allowable costs plus a fee
- FPIF (Fixed Price Incentive Fee) contracts include a ceiling price; costs above the ceiling are 100% seller responsibility
- Point of Total Assumption (PTA) is the cost point where the seller bears all additional costs in an FPIF contract
- Time & Materials (T&M) contracts fix unit rates but leave quantity open, creating a hybrid of fixed and cost-reimbursable characteristics
Procurement management involves acquiring products, services, or results from outside the project team. Understanding contract types and their risk allocation is essential for PMP exam success.
Procurement Management Processes
| Process | Purpose | Key Output |
|---|---|---|
| Plan Procurement Management | Determine what to procure and approach | Procurement Management Plan |
| Conduct Procurements | Obtain seller responses and select sellers | Agreements (Contracts) |
| Control Procurements | Manage relationships and monitor performance | Closed Procurements |
Make-or-Buy Analysis
Before procurement, organizations decide whether to produce internally or buy externally:
Factors Favoring Make (Insource)
| Factor | Reason |
|---|---|
| Core competency | Strategic capability to maintain |
| Cost advantage | Cheaper to produce internally |
| Control | Need tight control over quality or process |
| Capacity | Available internal resources |
| Intellectual property | Protect proprietary knowledge |
Factors Favoring Buy (Outsource)
| Factor | Reason |
|---|---|
| Specialized expertise | Skills not available internally |
| Cost advantage | Seller has economies of scale |
| Flexibility | Adjust resources as needed |
| Risk transfer | Shift risk to seller |
| Focus | Concentrate on core business |
Contract Types Overview
Contracts are categorized based on how they allocate risk between buyer and seller:
Risk Spectrum
| Contract Type | Buyer Risk | Seller Risk |
|---|---|---|
| Cost Plus (CPFF, CPIF) | Highest | Lowest |
| Time & Materials (T&M) | Moderate | Moderate |
| Fixed Price (FFP, FPIF) | Lowest | Highest |
Fixed-Price Contracts
Fixed-Price contracts establish a firm price for a defined scope of work. The seller bears most of the cost risk.
Firm Fixed Price (FFP)
| Aspect | Description |
|---|---|
| Price | Set at contract signing, does not change |
| Risk | Seller bears all cost risk |
| Best Use | Well-defined scope, low uncertainty |
| Seller Incentive | Complete efficiently to maximize profit |
Example: Contract for $100,000 to build a website with defined specifications.
- If seller's costs are $80,000 → Seller profit = $20,000
- If seller's costs are $120,000 → Seller loss = $20,000
Fixed Price Incentive Fee (FPIF)
| Element | Description |
|---|---|
| Target Cost | Expected cost to complete work |
| Target Profit | Expected seller profit |
| Target Price | Target Cost + Target Profit |
| Ceiling Price | Maximum buyer will pay |
| Share Ratio | How over/under runs are split (e.g., 70/30) |
FPIF Example:
- Target Cost: $100,000
- Target Profit: $15,000
- Target Price: $115,000
- Ceiling Price: $125,000
- Share Ratio: 70% Buyer / 30% Seller
If Actual Cost = $90,000 (Under Target):
- Savings = $100,000 - $90,000 = $10,000
- Seller Share = 30% x $10,000 = $3,000
- Final Price = $90,000 + $15,000 + $3,000 = $108,000
If Actual Cost = $110,000 (Over Target):
- Overrun = $110,000 - $100,000 = $10,000
- Seller Share = 30% x $10,000 = $3,000
- Final Price = $110,000 + $15,000 - $3,000 = $122,000
Point of Total Assumption (PTA)
The PTA is the cost point in an FPIF contract where the seller bears ALL additional costs:
PTA = [(Ceiling Price - Target Price) / Buyer Share Ratio] + Target Cost
Example:
- Ceiling Price: $125,000
- Target Price: $115,000
- Target Cost: $100,000
- Buyer Share: 70%
PTA = [($125,000 - $115,000) / 0.70] + $100,000 = $14,286 + $100,000 = $114,286
Above $114,286 in costs, the seller pays 100% of overruns.
Fixed Price with Economic Price Adjustment (FP-EPA)
| Aspect | Description |
|---|---|
| Use | Long-term contracts with inflation risk |
| Adjustment | Price adjusted based on economic indices |
| Protection | Seller protected from uncontrollable cost increases |
Cost-Reimbursable Contracts
Cost-Reimbursable contracts reimburse the seller for allowable costs plus a fee. The buyer bears most of the cost risk.
Cost Plus Fixed Fee (CPFF)
| Aspect | Description |
|---|---|
| Reimbursement | All allowable costs |
| Fee | Fixed amount (does not change with costs) |
| Best Use | Undefined scope, high uncertainty |
| Seller Incentive | Limited (fee is fixed) |
Example: Reimbursable costs plus $10,000 fixed fee.
- If costs = $100,000 → Buyer pays $110,000
- If costs = $150,000 → Buyer pays $160,000
Cost Plus Incentive Fee (CPIF)
| Element | Description |
|---|---|
| Cost Reimbursement | All allowable costs |
| Base Fee | Minimum fee seller receives |
| Incentive Fee | Additional fee based on performance |
| Share Ratio | How savings/overruns affect fee |
CPIF Example:
- Target Cost: $200,000
- Base Fee: $20,000
- Max Fee: $30,000
- Share Ratio: 80/20 (Buyer/Seller)
If Actual Cost = $180,000:
- Savings = $200,000 - $180,000 = $20,000
- Seller Incentive = 20% x $20,000 = $4,000
- Total Fee = $20,000 + $4,000 = $24,000
- Buyer Pays = $180,000 + $24,000 = $204,000
Cost Plus Award Fee (CPAF)
| Aspect | Description |
|---|---|
| Reimbursement | All allowable costs |
| Base Fee | Guaranteed minimum fee |
| Award Fee | Subjective evaluation by buyer |
| Criteria | Broad performance criteria |
Time and Materials (T&M) Contracts
T&M contracts are a hybrid of fixed-price and cost-reimbursable:
| Element | Fixed or Variable |
|---|---|
| Unit Rates | Fixed (e.g., $100/hour) |
| Quantity | Variable (open-ended) |
| Materials | Cost plus markup |
T&M Characteristics
| Aspect | Description |
|---|---|
| Best Use | Staff augmentation, undefined quantity of work |
| Risk | Shared; buyer controls quality, seller controls quantity |
| Duration | Often include "not to exceed" clauses |
| Management | Requires close oversight by buyer |
Contract Selection Criteria
Choosing the Right Contract Type
| Situation | Recommended Contract |
|---|---|
| Well-defined scope, low risk | FFP |
| Defined scope, incentive needed | FPIF |
| Undefined scope, R&D | CPFF or CPIF |
| Need quick start, scope evolving | T&M |
| Long-term, inflation concern | FP-EPA |
Procurement Documents
Key Documents
| Document | Purpose |
|---|---|
| RFI (Request for Information) | Gather information about seller capabilities |
| RFQ (Request for Quote) | Request pricing when scope is clear |
| RFP (Request for Proposal) | Request detailed proposals for complex work |
| IFB (Invitation for Bid) | Formal competitive bidding (government) |
Source Selection Criteria
| Criterion | Considerations |
|---|---|
| Technical Capability | Can seller perform the work? |
| Price/Cost | Total cost of ownership |
| Past Performance | Track record on similar work |
| Management Approach | How seller plans to manage work |
| Financial Stability | Will seller remain in business? |
Key Takeaways
- Fixed-Price contracts place maximum risk on seller; use when scope is well-defined
- Cost-Reimbursable contracts place maximum risk on buyer; use when scope is uncertain
- T&M contracts fix unit rates but leave quantity open; use for staff augmentation
- PTA is the point where seller bears 100% of additional costs in FPIF contracts
- FPIF includes ceiling price that caps buyer's maximum payment
- Select contract type based on scope clarity, risk tolerance, and desired incentives
In a Firm Fixed Price (FFP) contract, who bears the cost risk if actual costs exceed the contract price?
An FPIF contract has: Target Cost = $100,000, Target Profit = $10,000, Ceiling Price = $120,000, Share Ratio = 80/20. Calculate the Point of Total Assumption (PTA).
Which contract type is MOST appropriate when the scope of work is not well-defined and significant research and development is required?