Contract types

6.8.1 Contract types

Selecting contract type is a fundamental decision in the acquisi-tion process. There are two main types of contracts, fixed-price and cost-reimbursable, and a number of variants of them. In fixed-price contracts, the contractor assumes the main part of the cost risk. Because of this, the scope of the work needs to be well defined and attainable, and the work and any changes to the scope require strict management. In contrast, the customer assumes the main part of the cost risk for cost-reimbursable contracts. This requires an administrative overhead of keeping detailed and accurate cost and progress records. A benefit of cost-reimbursable contracts is that you can have a more flexible management of the work and changes to the scope, suitable for innovative projects or projects where the scope of the work is volatile. A drawback is that there is a lack of incentives to con-trol the cost and schedule, according to Urmi (2000).

According to Marciniak and Reifer (1990), there are two types of incentives: cost incentives and award incentives. Cost incen-tives can be used to motivate the contractor to shorten schedule or reduce cost. The fee is based upon how well the contractor meets cost or schedule objectives. However, a caveat should be given that if the target cost of the incentive fee structure is se-verely off target to the disadvantage of the contractor, the con-tractor might consider continuing to accrue labor hours in order to increase revenue and make up for the loss of fee. This possi-bility could be negated by having negative fees or penalties.

The customer should also consider stopping the work of the contractor to protect the budget.

Award incentives can be used to motivate the contractor to

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software quality, or for using certain software development

“best practices” such as peer reviews, configuration manage-ment, earned value, etc. Marciniak and Reifer (1990) argue that award fees need to be connected with the completion of a well-defined event. Brown, et al. (1998) presents some questions that should be of concern when using award incentives: How can the incentive targets be objectively evaluated? How will cases where factors beyond the control of the contractor impact the contractor’s achievement of the incentives criteria be dealt with? Are the additional administrative costs that will incur in managing the contract outweighed by the benefits achieved?

In the tables below the different variations on these two con-tract types and the time and materials concon-tract type are pre-sented. Each table contains a brief description on how the con-tract works, when it is applicable, who takes the main cost risk – contractor or customer, and also rates its administration level on a subjective scale from very low to very high. The contract types presented are the most common, although there are other contracting arrangements, such as basic ordering agreements, etc. When choosing contract type you could consider dividing the project into phases, such as a requirements elicitation phase followed by a software development phase, and have different contracting vehicles for each phase.

The contents of the contract types presented below are based upon Brown et al. (1998), Marciniak and Reifer (1990), Reifer (1997), and Wideman (1992).

FFP – Firm fixed price

Description The customer pays a fixed price for the con-tractors work.

Applicability FFP contracts apply for projects where the cost estimates are fairly reliable, the scope of the work is well defined and non-volatile, and the attainability of the project is very likely.

Cost risk Customer Contractor Administration Very low – if a lump sum is paid at final

de-livery.

Low – if partial payments are used (e.g.

monthly).

High – if partial progress payments are used (e.g. milestone driven).

FPEPA – Fixed price with economic price adjustment

Description A fixed price contract with price adjustments for certain costs for material, labor, travel ex-penses, etc.

Applicability Similarly to FFP contracts, FPEPA contracts apply for projects where the scope of the work is well defined and non-volatile and the attainability of the project is very likely. The FPEPA contract is specifically applicable for lengthier contracts where both parties need to be protected from certain cost fluctuations, such as airfares, etc. This contract can be combined with FPR.

Cost risk Customer Contractor

Administration Moderate – with lump sum payment.

High – with partial payments.

FPR – Fixed price redetermination

Description An initial fixed price is negotiated. Certain factors are agreed upon à priori for adjusting the price at specific times such as

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ments growth, changes in function points, etc.

Applicability The FPR contract applies to situations where the scope of the work is partially well defined and non-volatile and partially volatile.

Cost risk Customer Contractor

Administration Moderate

FPIF – Fixed price plus incentive fee

Description In addition to paying a fixed price, a variable fee is determined by negotiating the follow-ing parameters:

• Target and ceiling cost

• Minimum, maximum, and target fee

• Adjustment formula (or share ratio) The adjustment formula specifies how target cost underruns and overruns – without going over the ceiling cost – will be shared between the customer and contractor.

Applicability Similarly to FFP contracts, FPIF contracts ap-ply for projects where the cost estimates are fairly reliable, the scope of the work is well defined and non-volatile, and the attainability of the project is very likely. FPIF contracts can specifically be used as an instrument to moti-vate the contractor to increase efficiency, shorten schedule, and reduce cost. This con-tract can be combined with FPR.

Cost risk Customer Contractor

Administration Moderate – with lump sum payment.

High – with partial payments.

FPAF – Fixed price plus award fee

Description The contractor is paid a fixed price and a base fee. In addition, the contractor receives award fees when certain criteria are met. The base fee should be set low, around 3% of the target cost according to Marciniak and Reifer (1990), and the maximum fee could go up to 20%.

Applicability Similarly to FFP contracts, FPAF contracts apply for projects where the cost estimates are fairly reliable, the scope of the work is well defined and non-volatile, and the attain-ability of the project is very likely. FPAF con-tracts can specifically be used as an instru-ment to stimulate the contractor’s perform-ance in certain areas that are difficult to

measure objectively such as end user satisfac-tion, software quality, use of “best practices,”

etc.

Cost risk Customer Contractor

Administration High

CS – Cost and cost share

Description In a cost share contract the customer and con-tractor agree on the ratio by which they will share costs. In a cost contract the customer pays for all allowable costs. The contractor re-ceives no fee in either contract type.

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Applicability Cost share contracts apply for joint develop-ment efforts where both parties share risk in order to share the future rewards from the product. Cost contracts apply for projects with nonprofit organizations.

Cost risk 100% by the customer for cost contracts.

Shared, according to the agreed ratio, for cost share contracts.

Administration High

CPFF – Cost plus fixed fee

Description The contractor's allowable costs are reim-bursed and a fixed fee is paid upon delivery.

Applicability CPFF contracts apply for projects where the costs cannot be reasonably estimated such as innovative projects or projects where the scope of the work is volatile or difficult to de-fine.

Cost risk Customer Contractor

Administration High

CPPF – Cost plus percentage fee

Description The contractor’s allowable costs are reim-bursed and a percentage of the costs is re-ceived as a fee.

Applicability CPPF contracts apply for projects where the costs cannot be reasonably estimated such as

innovative projects or projects where the scope of the work is difficult to define.

Cost risk Customer Contractor

Administration High

CPIF – Cost plus incentive fee

Description In addition to reimbursing the contractor’s al-lowable costs, a variable fee is determined by negotiating the following parameters:

• Target and ceiling cost

• Minimum, maximum, and target fee

• Adjustment formula (or share ratio) The adjustment formula specifies how target cost underruns and overruns – without going over the ceiling cost – will be shared between the customer and contractor.

Applicability Similarly to CPFF contracts, CPIF contracts apply for projects where the costs cannot be reasonably estimated such as innovative pro-jects or propro-jects where the scope of the work is difficult to define. CPIF contracts can spe-cifically be used as an instrument to motivate the contractor to increase efficiency, shorten schedule, and reduce cost.

Cost risk Customer Contractor

Administration Very high

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CPAF – Cost plus award fee

Description The contractor is reimbursed for allowable costs and receives a base fee. In addition, the contractor receives award fees when certain criteria are met. The base fee should be set low, around 3% of the target cost according to Marciniak and Reifer (1990), and the maxi-mum fee could go up to 20%.

Applicability Similarly to CPFF contracts, CPAF contracts apply for projects where the costs cannot be reasonably estimated such as innovative pro-jects or propro-jects where the scope of the work is difficult to define. CPAF contracts can spe-cifically be used as an instrument to stimulate the contractor’s performance in certain areas that are difficult to measure objectively such as end user satisfaction, software quality, use of “best practices,” etc.

Cost risk Customer Contractor

Administration Very high

TM/L – Time and materials / Labor hours

Description The contractor is paid an hourly rate for the time to perform the agreed upon work and is reimbursed for any necessary purchases.

Applicability TM/L contracts apply for projects where the extent and duration of the work cannot be reasonably estimated. The contract type suits projects where you want to be able to quickly change the direction of the work and can monitor the work closely. A ceiling price

should be determined.

Cost risk Customer Contractor

Administration Low

The table below gives suggestions for what contract types to consider for the different customization levels:

Minimal FFP, FPR, FPIF, TM/L

Controlled FPEPA, FPR, FPIF, CS, CPFF, CPPF, CPIF Robust FPEPA, FPR, FPIF, FPAF, CS, CPFF, CPPF,

CPIF, CPAF