Contracts :: In Depth

A Contract is a legal document between a buyer and seller. As it is legally binding, it will be subjected to formal approval process.

- It is a mutually binding document that obligates
   - The Seller to provide something of value (e.g.. Product, Service, Result) 
   - The Buyer to provide monetary or other valuable compensation

- Risks are shared or transferred: Identifiable risks are shared or transferred to Seller from Buyer through Contract

- Terms and Conditions :: Contract includes Terms and Conditions that Buyer specifies as to what the seller to provide or perform, when the contract completes, when the contract can be terminated by either parties etc..

- Different Names: Contract can be called as an agreement, understanding, sub contract or a Purchase Order.

Contract Categories in Detail:

1. Fixed Price Contracts:  This category of contracts involves setting a fixed total price for a defined product, service or result to be provided by the Seller.  The risk is totally transferred to the Seller. Buyer has to prepare detailed scope at the beginning of the work.

(1.1) Firm Fixed Price  Contract (FFP): This is most commonly used contract type. Most of the buyers favors this contract primarily due to:

(i.) Price is set at the outset and not subjected to change unless scope of the work changes.

(ii.) Any cost increase due to adverse performance is the responsibility of the seller. Thus, Seller assumes the all the risk here. Thus, sellers will charge additional costs in their cost estimates as they are taking complete risk. FFP is most expensive than other contract.

Buyers should precisely specify the product or services to be procured at the start of the work and any changes to the procurement scope can increase the costs to the buyer.

Buyer does not need to audit the invoices of the Seller here as the price is fixed and it is only that Buyer needs to pay at the agreed payment milestones.

Seller can profit if they control their costs well

Buyers has less risk to manage

Caution for Buyers: Sellers raises change requests incase of scope change.  In a scenario, where Seller under prices the original work, they may tend to recover or make up that under estimated price through high cost estimates for CRs. Thus, Buyers have to strictly define the Change Control Procedures and implement them while approving the CRs.

(1.2)  Fixed Price  Incentive Fee Contract (FPIF): This arrangement gives the buyer and seller flexibility for deviation from performance, with financial metrics related to cost, schedule, scope, quality and ability to respond to change and associated risks etc.  These metrics get established at the beginning of the work. Thus, Final Price is determined after completion of all the work. Sellers assume less risk compared to Firm Fixed Price Contract as they have provision to gain more profits due to their good performance.

Key Terms used during FPIF Contract:

(.i.) Target Cost : Seller's Estimated Cost at the beginning of the work.

(.ii.) Target Fee: We generally speak from Buyer's point of view. Thus, we use the term "Fee". It is the mandatory fee that Buyer has to pay to the Seller for the contractual work performed.  From Seller point of view, it is the profit, they keep as margin on top of their Target Cost.

(.iii.)  Target Price = Target Cost + Target Fee

(.iv.) Buyer Seller Ratio = The ratio Buyer and Seller has to bear the deviated costs from the Target cost.

For example, we have scenario where Target Estimate Cost is Rs 10,000, Buyer: Seller = 60:40, Actual incurred costs by Seller is Rs16,000. That means, we apply Buyer Seller ratio on the deviated cost (i.e. 6000 = 16,000 - 10,000). Buyer has to bear the additional costs by 60% of 6000 = Rs 3600. and Seller has to bear the additional costs by 40% of Rs 6000 = Rs 2400. Like wise, incase Seller shows better performance and completes the work with actual costs Rs 4000. That is the profit incurred is Rs 6000. Buyer shares the profit by 60% of 6000 (Rs 10,000 - Rs 4000)= Rs 3600. Seller shares the profit by 40% of 6000 (Rs 10,000 - Rs 4000) = Rs 2400.

(.iv.) Adjusted Fee = Target Fee +/- Performance based fee based on Buyer Seller ratio specified

(.v.) Final Fee = Target Cost + Adjusted Fee

(.vi.) Ceiling Price(Not mentioned we have to assume as Upper Ceiling Price) = Ceiling Costs beyond which Buyers cannot pay. Seller has to bear the costs. This is to protect the Buyer from incurring infinite costs

(.vii.) Lower Ceiling Price: It is the minimum Price, Buyer has to pay to the seller however adverse the performance may be. This is to protect Seller from incurring infinite losses.

(1.3)  Fixed Price with Economic Price Adjustment Contract (FP-EPA): This contract type is used in long term contracts where Seller costs can increase because of factors beyond Seller's control (e.g. inflation, cost increase/decrease for specific commodities). The EPA clause needs to relate to some reliable financial index which is used to adjust the final price. The FP-EPA contract is used to protect both buyer and seller from external conditions beyond their control.

Example: A contract worth USD 1,000,000 a year for 5 yeas + A Price  increase will be allowed every year based on the index (ex. US Consumer Price Index).

2. Cost Reimbursable Contracts:  This category of contract involves payments (cost reimbursement to the seller for all legitimate actual costs incurred for the completed work + a fee representing the seller profit).

Cost reimbursable contract may also include financial incentive/penalty clauses whenever the seller exceeds or falls below, defined objectives such as costs, schedule or technical performance targets.

Three of more common types of cost-reimbursable contracts in use are"

(2.1) Cost Plus Fixed Fee (CPFF)
(2.2) Cost Plus Incentive Fee (CPIF)
(2.3) Cost Plus Award Fee (CPAF)

A cost-reimbursable contract provides the project flexibility to redirect a seller whenever the scope of work cannot be precisely defined at the start and needs to be altered or when high risks may exists in the effort

(2.1) Cost Plus Fixed Fee (CPFF):  The seller is reimbursed for all allowable costs for performing the contract work and receives a fixed-fee payment calculated as a percentage  of initial estimated project costs.  A fee is paid only for completed work and does not change due to seller performance. Fee amounts do not change unless the project scope changes.

(2.2) Cost Plus Incentive Fee (CPIF): The Seller is reimbursed for all allowable costs for performing the contract work and receives a predetermined incentive fee based upon achieving certain performance objectives set forth in the contract.

In CPIF contracts, if final costs are less or greater than the original estimated costs, then both buyer and seller share the costs based on the pre-negotiated cost sharing formula (Buyer and Seller Ratio). For example an 80/20 split over/under target costs based on the actual performance of the seller.

(2.3) Cost Plus Award Fee (CPAF): The Seller is reimbursed all legitimate costs, but the majority of the fee is earned only based on the satisfaction of certain broad subjective performance criteria defined and incorporated into the contract.

The determination of fee is based solely on the subjective determination of seller performance by the buyer, and is generally not subject to appeals.

Let us take an example of building software consisting of 10 features. The legitimate costs are $10,00,000 and the target fee is $1,00,000.  The Seller is paid the legitimate costs incurred of worth $10,00,000. Out of the Fee $1,00,000, award fee criterion is 30% will be released when analysis got approved by Buyer Board, 40% will be granted when Software is passed in User Acceptance Testing. Remaining 30% will be released when the software is deployed and warranty support of one month is provided.

The key difference between CPIF and FPIF contracts is that CPIF does not include Ceiling Price and that Buyer has to pay all the legitimate costs incurred by the Seller.

3. Time and Material Contracts (T&M) - It is hybrid type of contractual arrangements that contain aspects of both cost-reimbursable and Fixed Price Contracts. 

 - CR because these are open Ended: It resembles Cost Reimbursable contracts as the scope ( full value of the agreement) cannot be precisely be defined at the start of the awarding the contract and may subject to increase in costs to the buyer.

- FP because certain Parameters (unit labor, unit material rates) are pre-set: Buyers and sellers agree in fixing the price for these parameter rates per hour or material unit rate that will not change subsequently.

Thus, T&M contracts can increase costs to buyer as they are open ended. To protect the Buyer, not to exceed clause is used similar to what we have seen FPIF contract.

T& M contracts are used for staff augmentation and acquisition of experts. This contract is also used when Buyer have to procure any outside support and precise statement of work cannot be quickly defined.