Type of Contracts

My Purchasing Portfolio by Dayal Divyanshu e-mail [email protected]

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TYPE OF CONTRACTS

Contents 1. Factors in Selecting Contract Types............................................................................................................................................ 3

i. Price Competition .................................................................................................................................................................... 3

ii. Price Analysis ........................................................................................................................................................................... 3

iii. Cost Analysis ............................................................................................................................................................................ 3

iv. Type and Complexity of the Requirement ............................................................................................................................. 3

v. Combining Contract Types ...................................................................................................................................................... 3

vi. Urgency of the Requirement .................................................................................................................................................. 3

vii. Period of Performance or Length of Production Run ....................................................................................................... 3

viii. Contractor’s Technical Capability and Financial Responsibility ....................................................................................... 3

ix. Adequacy of the Contractor's Accounting System ................................................................................................................ 3

x. Concurrent Contracts .............................................................................................................................................................. 3

xi. Extent and Nature of Proposed Subcontracting ................................................................................................................... 3

xii. Acquisition History .............................................................................................................................................................. 3

2. Types of Contracts ....................................................................................................................................................................... 4

i. Unit Price Contract .................................................................................................................................................................. 4

ii. Fixed Price Contract/ Lumpsum Contract .............................................................................................................................. 4

-Sub Categories of Fixed Type Contract ..................................................................................................................................... 4

a. Fixed Price Contracts with Economic Price Adjustment ....................................................................................................... 4

b. Fixed Price Contracts with Economic Price Adjustment and Award Fee or Incentive........................................................ 4

c. Fixed Price Incentive Contracts ............................................................................................................................................... 4

d. Fixed Price Contracts with Prospective Price Redetermination ........................................................................................... 6


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iii. Cost Reimbursement or Cost Plus Contracts ......................................................................................................................... 6

Application ................................................................................................................................................................................... 6

-Sub categories of Cost Reimbursement/ Cost Plus Contracts................................................................................................. 6

a. Cost Plus Fixed Percentage Contract ................................................................................................................................. 6

b. Cost Plus Fixed Fee Contract .............................................................................................................................................. 6

c. Cost Plus Fixed Fee with Guaranteed Maximum Price Contract ..................................................................................... 6

d. Cost Plus Fixed Fee with Bonus Contract........................................................................................................................... 6

e. Cost Plus Fixed Fee With Guaranteed Maximum Price and Bonus Contract .................................................................. 6

f. Cost Plus Incentive Fee Contract (CPIF) ............................................................................................................................ 6

iv. Implied Contract/ Quasi Contract .......................................................................................................................................... 7

v. Unilateral Contract .................................................................................................................................................................. 7

vi. Bilateral contract ..................................................................................................................................................................... 7

3. Performance & Delivery Incentives ............................................................................................................................................ 7


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1. Factors in Selecting Contract Types

i. Price Competition Results in realistic pricing.

ii. Price Analysis Provides a basis for selecting the contract type.

iii. Cost Analysis In the absence of effective price competition and if price analysis is not sufficient, the cost estimates of the contractor and the client

provides the basis for negotiating contract pricing arrangements. It is essential that the uncertainties involved in performance and their possible impact upon costs be identified and evaluated.

iv. Type and Complexity of the Requirement Complex requirements, particularly those unique to the client, usually result in greater risk assumption by the client. For complex research and development contracts, when performance uncertainties or the likelihood of changes makes it difficult to

estimate performance costs in advance. As a requirement recurs or as quantity production begins, the cost risk should shift to the contractor, and a fixed price contract should be considered.

v. Combining Contract Types If the entire contract cannot be firm fixed price, the contracting officer shall consider whether or not a portion of the contract can

be established on a firm fixed price basis.

vi. Urgency of the Requirement If urgency is a primary factor, the client may choose to assume a greater proportion of risk or it may offer incentives tailored to

performance outcomes to ensure timely contract performance.

vii. Period of Performance or Length of Production Run In times of economic uncertainty, contracts extending over a relatively long period may require economic price adjustment or price

redetermination clauses.

viii. Contractor’s Technical Capability and Financial Responsibility

ix. Adequacy of the Contractor's Accounting System Before agreeing on a contract type other than firm fixed price, the contracting officer shall ensure that the contractor’s accounting

system will permit timely development of all necessary cost data in the form required by the proposed contract type.

x. Concurrent Contracts If performance under the proposed contract involves concurrent operations under other contracts, the impact of those contracts,

including their pricing arrangements, should be considered.

xi. Extent and Nature of Proposed Subcontracting If the contractor proposes extensive subcontracting, a contract type reflecting the actual risks to the prime contractor should be

selected.

xii. Acquisition History Contractor risk usually decreases as the requirement is repetitively acquired. Also, product descriptions or descriptions of services

to be performed can be defined more clearly.


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2. Types of Contracts

i. Unit Price Contract Based on estimated quantities of items included in the project and their unit prices. The final price of the project is dependent on

the quantities needed to carry out the work. It is not unusual to combine a unit price contract for parts of the project with a lump Sum/ fixed price contract or other types of

contracts. Application This contract is only suitable for construction and supplier projects where the different types of items, but not their numbers, can

be accurately identified in the contract documents.

ii. Fixed Price Contract/ Lumpsum Contract Provides for a firm price or, in appropriate cases, an adjustable price. Fixed price contract providing for an adjustable price may include a ceiling price, a target price (including target cost), or both. This contract type places upon the contractor maximum risk and full responsibility for all costs and resulting profit or loss. Application Acquiring commercial items or for acquiring other supplies or services on the basis of reasonably definite functional or detailed

specifications, when reasonable prices can be established at the outset.

-Sub Categories of Fixed Type Contract

a. Fixed Price Contracts with Economic Price Adjustment A fixed-price contract with economic price adjustment provides for upward and downward revision of the stated contract price

upon the occurrence of specified contingencies. Economic price adjustments are of three general types 1. Adjustments based on established prices: These price adjustments are based on increases or decreases from an agreed upon level

in published or otherwise established prices of specific items or the contract end items. 2. Adjustments based on actual costs of labor or material: These price adjustments are based on increases or decreases in specified

costs of labor or material that the contractor actually experiences during contract performance. 3. Adjustments based on cost indexes of labor or material: These price adjustments are based on increases or decreases in labor or

material cost standards or indexes that are specifically identified in the contract.

b. Fixed Price Contracts with Economic Price Adjustment and Award Fee or Incentive The contracting officer may use a fixed price contract with economic price adjustment in conjunction with an award fee incentive

and performance or delivery incentives when the award fee or incentive is based solely on factors other than cost. The basis for all award fee determinations shall be documented in the contract file to include, at a minimum, a determination that

overall cost, schedule and technical performance in aggregate is or is not at a satisfactory level. Provides for evaluation period(s) to be conducted at stated intervals during the contract period of performance so that the

contractor will periodically be informed of the quality of its performance and the areas in which improvement is expected (e.g. six months, nine months, twelve months, or at specific milestones).

Defines the total award fee pool amount and how this amount is allocated across each evaluation period.

c. Fixed Price Incentive Contracts A fixed price incentive contract is a fixed price contract that provides for adjusting profit and establishing the final contract price by

a formula based on the relationship of final negotiated total cost to total target cost. Point of Total Assumption (PTA) is a term used to evaluate the fixed price incentive (FPI) contract price and the final fee to be paid

to the contractor. PTA is a point on the cost line of the profit cost curve determined by the contract elements associated with a fixed price plus

incentive firm target contract above which the seller effectively bears all the costs of a cost overrun. In addition, once the costs on an FPI contract reach PTA, the maximum amount the buyer will pay is the ceiling price. Note, however, that between the cost at PTA and when the cost equals the ceiling price, the seller is still in a profitable position; only when costs exceed the ceiling price then the seller is in a loss position.


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-Calculation of Point of Total Assumption (PTA)

Any FPI contract specifies following costs: 1. Target Cost.

2. Target Profit.

3. Target Price.

4. Ceiling Price.

5. One or more share ratios.

The PTA is the difference between the ceiling and target prices, divided by the buyer's portion of the share ratio for that price range, plus the target cost.

Example on calculation of PTA

Target Cost: USD 2,000,000

Target Profit: USD 200,000

Target Price: USD 2,200,000 ( Target cost + Target profit) Ceiling Price: USD 2,450,000 Share Ratio: 80% buyer & 20% seller for overruns and 50% & 50% for under runs

PTA = ((2,450,000 - 2,200,000)/ 0.80) + 2,000,000 = 2,312,500.

Example on calculation of profit

A Fixed Price Plus Incentive Fee (FPI) Contract has a target cost of USD 130,000, a target profit of USD 15,000, a target price of USD 145,000, a ceiling price of USD 160,000, and a share ratio of 80/20. The actual cost of the project was USD 150,000. How much profit does the seller make?

Calculations:

PTA = (160,000 – 145,000)/0.80 + 130,000 = USD 148,750.

Total cost at the point of total assumption is = USD 148,750.

Over run at point of total consumption = (Total Cost at PTA - Target Cost)

(148,750 – 130,000)= USD 18,750.

Buyer share = (0.80 x 18,750)= USD 15,000. Seller share = (0.20 x 18,750)= USD 3,750. Note, the cost up to that point was agreed to be split between parties. If total cost equals PTA, then seller would have a profit reduced by (target profit – sellers overrun share) = (15,000 – 3,750) = USD

11,250

Now, with the actual total cost of USD 150,000, every dollar above cost USD 148,750 (Total cost at PTA) will be taken directly from the sellers profit. So, the final profit will be = 11,250 – (150,000-148,750) = USD 10,000

PTA = ((Ceiling Price - Target Price)/buyer's Share Ratio) + Target Cost


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d. Fixed Price Contracts with Prospective Price Redetermination A firm fixed price for an initial period of contract deliveries or performance and prospective price redetermination at a stated time

during performance of the price for subsequent periods of performance. The initial period should be the longest period for which it is possible to negotiate a fair and reasonable firm fixed price. Each

subsequent pricing period should be at least 12 months. Application A fixed price contract with prospective price redetermination may be used in acquisitions of quantity production or services for

which it is possible to negotiate a fair and reasonable firm fixed price for an initial period, but not for subsequent periods of contract performance.

iii. Cost Reimbursement or Cost Plus Contracts Cost reimbursement types of contracts provide for payment of allowable incurred costs to the extent prescribed in the contract. These contracts establish an estimate of total cost for the purpose of obligating funds and establishing a ceiling that the contractor

may not exceed (except at its own risk) without the prior approval of the contracting officer. Application Cost reimbursement contracts to be used only when circumstances do not allow the agency to define its requirements sufficiently to allow for a fixed price type contract. -Sub categories of Cost Reimbursement/ Cost Plus Contracts a. Cost Plus Fixed Percentage Contract Compensation is based on a percentage of the cost. b. Cost Plus Fixed Fee Contract Compensation is based on a fixed sum independent of the final project cost. The client agrees to reimburse the contractor's actual costs, regardless of amount, and in addition pay a negotiated fee independent of the amount of the actual costs. c. Cost Plus Fixed Fee with Guaranteed Maximum Price Contract Compensation is based on a fixed sum. The total project cost should not exceed an agreed upper limit. d. Cost Plus Fixed Fee with Bonus Contract Compensation is based on a fixed sum and bonus given if the project finishes below budget, ahead of schedule or based on other agreed parameters as stipulated in contract. e. Cost Plus Fixed Fee With Guaranteed Maximum Price and Bonus Contract Compensation is based on a fixed sum. The total project cost will not exceed an agreed upper limit and a bonus is given if the project is finished below budget, ahead of schedule or based on other agreed parameters as stipulated in contract. f. Cost Plus Incentive Fee Contract (CPIF) A cost reimbursement contract that provides for an initially negotiated fee to be adjusted later by a formula based on the

relationship of total allowable costs to total target costs. Unlike a cost plus contract, the cost in excess of the target cost is only partially paid according to a Buyer/Seller ratio. The seller's

profit decreases when exceeding the target cost. Similarly, the seller's profit increases when actual costs are below the target cost defined in the contract.

Incentive contracts allow sharing of the risks between the contractor and the client. The contractor is reimbursed all its justifiable costs in addition to a calculated fee.


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The basic elements of a CPIF contract Major Costs in CPIF calculation (Similar to the costs terminologies in fixed price contract) Target cost.

Actual cost.

Target fee: The Target Fee varies between the Minimum Fee and the Maximum Fee according to a formula tied to the Actual Cost

(e.g. Target Fee could be 10% of the Actual Cost).

Sharing ratio: The agreed upon cost sharing proportion, normally expressed in percentage (e.g. 85% for the client / 15% for the

contractor). It is often different for cost overruns and cost underruns. Other components of incentive fee contracting include

Maximum Fee: the highest fee that may be earned, usually expressed as a percentage.

Minimum Fee: the lowest fee that may be earned, usually expressed as a percentage.

The Final Fee (profit of the contractor) is expressed as follows:

Final Fee = Target Fee + (Target Cost - Actual Cost) * Contractor Share

The Final Price of the contract is expressed as follows:

Final Price = Actual Cost + Final Fee

For example, assume a CPIF with:

Target Cost = USD 1,000. Target Fee = USD 100. Benefit/Cost Sharing Ratio for cost overruns = 80% Client / 20% Contractor. Benefit/Cost Sharing Ratio for cost underruns = 60% Client / 40% Contractor.

If actual cost: USD 1,100.

Client will pay to the contractor: 1,100 + 100 + (1,000 - 1,100) * 0.2 = 1,180 (contractor earns USD 80 instead of USD 100).

If the Actual Cost is lower than the Target Cost: USD900

Client will pay to the contractor: 900 + 100 + (1,000 - 900) * 0.4 = 1,040 (contractor earns USD 140 instead of USD 100).

iv. Implied Contract/ Quasi Contract A contract is implied if the circumstances imply that parties have reached an agreement even though they have not done so expressly.

v. Unilateral Contract One party makes a promise, but the other side does not promise anything. In these cases, those accepting the offer are not required to communicate their acceptance to the offer.

vi. Bilateral contract An agreement in which each of the parties to the contract makes a promise or set of promises to each other. 3. Performance & Delivery Incentives Performance incentives may be considered in connection with specific product characteristics (e.g., a missile range, an aircraft speed, an engine thrust, or vehicle maneuverability) of the contractor’s performance. These incentives should be designed to relate profit or fee to results achieved by the contractor, compared with specified targets. Delivery incentives should be considered when improvement from a required delivery schedule is a significant objective.

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Type of Contracts