How to select the best type of contract for your project
Having a good understanding of how procurement works is a key requirement for a project manager, or anyone involved in the process of managing projects. Procurement starts when a need or requirement is identified within an organization whether that is a new product, service, software application or the renewal of a new contract. In any such example, the procurement process must start in order to establish a procurement plan and carry out procurement activities that starts with the selection of potential suppliers through to the signing of a contract; ongoing contract management, and then finally contract closure. This article focuses on the buyer and the project manager’s role within procurement specifically during the planning process where contracts are defined.
In general terms a company or entity providing goods or services is called a contractor, a supplier or a vendor and is referred to as a seller. The company or entity who purchases the same is known as the buyer. Within a single organization, procurements can be entered into as a buyer or as a seller.
The basic knowledge and skills of procurement management is a must for any project manager and includes being able to help create, read and manage different types of contracts and understand important legal aspects contained within them. This understanding is important when the project manager is setting up a project and is looking to purchase or acquire third-party products or services and needs to engage sellers outside of the project team or organization.
The project manager must make contact with the procurement department and ask for support in preparing and managing the procurement process that will be needed throughout the project lifecycle. This department can either be centralized; where there is a single procurement department that handles all contracts for the entire organization or decentralized; where a procurement manager can be assigned to a project part or full-time. Where a centralized department is more likely to provide standardized practices and greater levels of expertise, they may not have the time when it’s needed to work on a project, whereas having someone allocated and a member of the project team in a decentralized environment also has advantages most importantly their loyalty to the project.
With the PMBOK® Fifth Edition:
Plan Procurement Management is completed during the Planning Process Group
Conduct Procurements is completed during the Executing Process Group
Control Procurements is completed during the Monitoring and Controlling Process Group
Close Procurements is completed during the Closing Group
Once the procurement expert is engaged, the first step is to create a procurement management plan which defines what products and services will be purchased externally, how and when they will be purchased and which sellers best meet the project’s requirements.
The procurement management plan should include the following activities.
Conducting a make-or-buy analysis
This activity determines whether the organization should complete the project work themselves or outsource some or all of the work to a third-party. When considering completing the work inside the organization the assessment must include internal capability, resource availability, cost, schedule, quality and associated risks. When considering outsourcing, attention must be given to supplier relationships, scope and contract types that can be used to transfer or share risks with a seller. One of the main reasons to outsource is to decrease risk to the project’s constraints.
For both options, direct and indirect costs must be taken into account; direct costs are those of making or acquiring the product or service, and the indirect costs for supporting the purchasing process and purchased item. For example, if the organization purchases a new IP desktop system, costs must be calculated for the internal support the system will require during installation, the communication and training requirements during the rollout, and the ongoing operational support and maintenance.
If a buy decision is made, then the next decision is whether to purchase or lease it from the seller. The buy-or-lease costs can be determined by the project manager by working out the breakeven point against the project or product lifecycle requirements.
Preparing a procurement management plan
The project manager will prepare a procurement management plan that states how procurements will be planned, executed and controlled and then finally closed. The contents should include:
Planning that establishes the overarching procurement governance framework, the guidelines for the make-or-buy process, standard and non-standard procedures, and state how the procurement documents; the statement of work (SoW) and terms and conditions for contracts will be created. It will define the standards for selecting the correct contract type and for establishing the selection criteria for the sellers.
Executing the project includes documenting the roles and responsibilities of the project team, the overall process of how conduct procurement will be managed from sourcing and shortlisting prospective sellers through to contract signing. It should also include the rules and guidelines the sellers must follow during the tender process from bidder conferences through to negotiations.
Controlling will define how the SoW and terms and conditions will be measured through key performance indicator (KPI) measurements. The best KPIs for contract management are ones that are: specific, measurable, achievable, results-oriented, and time-constrained; known as SMART KPIs and serve as a measure that helps the project manager track the performance of the contract. Controlling also should define guidelines for handling contract disputes, the process for accepting deliverables and when payments will be made.
Closing documents how a procurement will be closed and the steps to be taken when a contract is completed or terminated before the work is completed. Formal acceptance and closure includes product or service validation to determine if the work was carried out correctly, procurement negotiation of outstanding invoices and claims, financial closure, procurement audits and lessons learned.
Selecting a statement of work and contract type for each procurement
The SoW describes the work and activities that the seller is required to complete. Statements of work include:
- Performance type; what the final product should be able to accomplish.
- Functional type; what the end purpose or the results should be rather than the specific procedures or approach and
- Design type; precisely what work is to be done.
When selecting a contract type, the project manager has three main categories to choose from as follows:
- Fixed price (FP)
- Time and materials (T&M)
- Cost-reimbursable (CR)
The FP and T&M are the most commonly used across all industries, however CR can be a very good option for both the buyer and the seller.
Fixed price contract
These types of contracts, also known as firm fixed price (FFP) or lump sum contracts are negotiated between the buyer and seller and then fixed at an agreed price. However the contract is more effective when a clearly defined specifications are known and incorporated into the statement of work. It is the obligation of the buyer to define and document these details into the statement of work (SoW) which form part of the contract. With such contracts the seller takes on the risk therefore if the costs exceed the agreed upon amount then the seller must bear these additional costs. Under the terms and conditions of the fixed price contract, seller has a legal obligations to complete the work as specified and are faced with the possibility of financial damages if they do not.
FP contracts are typically used within the IT industry particularly for large scale outsourcing and management service contracts and over recent years the tender process timelines for sellers to prepare and submit proposals have been reduced, mainly driven by the buyer and/or their consultants engaged to manage the tender process. Where large tenders could take up to twelve months, now they are being completed in as little as three months. This leads to significantly higher risks, particularly for the seller as they are unable to complete the required level of due diligence needed to fully understand and define the scope and requirements. This combined with a desire for the seller to win in a highly competitive market, the seller will submit a reduced price; down-selection of seller’s follows usually with modifications to the proposal and further price reductions. This is then followed by a best and final offer (BAFO) and heavy contract negotiations which will in most cases lead to a final contract which lacks quality but with a commitment to the buyer at a fixed price.
The seller will add cost to the proposal to cover risks and assumptions; however when working to very aggressive timelines, more often than not, risks and assumptions also suffer with a lack of quality and therefore do not provide the necessary coverage needed for the seller.
If problems then occur during the contract, which typically surface early on in the project or implementation phase, claims and disputes over what is in, and what is out of the contract will arise. If the seller is then faced with losing whatever profit they had within the contract, there is a risk to the buyer that their best people are removed and corners are taken to reduce scope and quality to try and save money. This is a typical problem with a FFP contract and the buyer has no visibility of profit as it is not separated like it is in other FP and CR contracts.
It is very important that for all fixed price contracts the buyer provides a statement of work where the scope and requirements are clearly defined and that the appropriate amount of time is given to complete the work which will allow the seller to prepare an accurate proposal.
In addition to the FFP contract, FP contracts can also include financial incentives for achieving or exceeding selected project objectives, such as schedule delivery, dates, cost and technical performance, or anything that can be quantified and subsequently measured. The other types of fixed price contracts include:
- Fixed Price Incentive Fee (FPIF): In this type of contract profits or financial incentives can be adjusted based on the seller meeting specific performance based criteria or KPIs typically related to cost, schedule or technical performance. Here the target costs and target profit are agreed upfront and then combined to give an overall target price. In addition a ceiling price is included stating the maximum amount the buyer will pay (costs and fee combined) for the total project. As the price is fixed then only target profit element of the target price can be adjusted, either up or down, and is calculated using a formula, for example; 60 percent to the buyer and 40 percent to the seller. Then depending on the performance of the seller, the target profit is adjusted based on the 40 percent ratio. The risk to the seller is that if they significantly under perform they will lose all of their target profit. In addition, a point of total assumption (PTA) is also included which is the amount which if exceeded the seller bears all costs overruns. 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. An example of a FPIF; a time KPI can be included, so for every calendar month early the project is finished, an additional 5,000 € is paid to the seller up to a maximum ceiling price of 60,000 €.
- Fixed Price Award Fee (FPAF): Similar to the FPIF contract, the buyer pays to the seller a fixed price plus a capped bonus or award amount, if the seller meets or exceeds specific performance based criteria or KPIs. For example; if the seller’s performance exceeds the rollout of a service to more than 50 locations per month a 3,000 € amount is paid to the seller up to a maximum amount capped at 36,000 €. For this type of contract to be fully effective, a governance board needs to be in place together with clearly defined KPIs than can be measured to ensure fair payment to the seller.
- Fixed Price Economic Price Adjustment (FPEPA): In this type of contract the fixed price can be redetermined depending on the market pricing rate. This benefits long-running contracts particularly global projects that span a number of countries where interest rates will fluctuate and where the cost of equipment and materials is likely to change. For example; the contract value is 1,4000,000 € but a price increase will be allowed in years two and three based on the interest rate index of the European Central Bank.
Purchase order (PO) and Purchase Agreements (PA)
In addition to the fixed FP contracts above, a more basic type of fixed price contract is a purchase order. Like the FP contracts, a PO is a legally binding document between a seller and the buyer and details the items to purchase by both parties at a agreed price and includes other details like the delivery date and terms of payment for the buyer. The difference with a PO is that it is unilateral, meaning that it is signed by only one party (usually the buyer), whereas all the other FP contracts are bilateral and signed by both parties.
Many companies set up bilateral Purchase Agreements (PA) with sellers which details the duty and rights of both parties and includes general terms and conditions, responsibilities, inspection, price and payment, confidentiality, international commercial terms, term and termination, remedy for breach of the contract and warranty, as examples. POs are then raised against a PA with specific requirements. The PA and PO have different purposes but are designed to work together to specify the terms of an order.
Time and material contract
A time and material contract, also known as a unit price contract, are used for purchasing a seller’s services, which is based on a per-hour, per-day rate, or per-item basis and would include direct and indirect costs plus profit. The T&M contract is easier to set up as the terms and conditions are less complicated which allows for quicker negotiation and agreement with a supplier that can bring flexibility to a project when work has to start immediately. T&M contracts are useful for short-term contracts, smaller procurements or commodity services and can be used when the level of work cannot be clearly defined. It is important for the project manager to take time writing a detailed PO so that the scope, requirements and deliverables are clearly stated within the contract. If a standard PO is raised internally by the project team or organization, a separate document can be attached containing the detail of work required, which will form part of the contract.
When the contract is based on an hourly rate it has a known fixed price element but an unknown time to complete the work, therefore depending on what is being purchased, regular reviews are required to ensure the work in on track. In some cases adding a cap or limit to the contract is a good option to reduce the risk to the buyer.
Usually materials are charged in addition and at a cost rate when the seller is providing a time based service; when it is on a per-item basis, the materials are usually included in the rate. Where materials are itemized and charged at a cost rate they may be subject material handling costs which are categorized as indirect costs, such as purchasing, inspection and storage and can charged as a percentage of the material purchased to carry out the work.
A cost-reimbursable contract, also know as a cost plus contract, is less popular and underutilized, but can be very effective when the scope of work is not well defined, is subject to change or modification. It is more commonly used for IT projects, research and development projects and by government bodies. Initially the seller provides estimated costs to the buyer who can then use the estimate for budgetary planning and cost management purposes. This estimate once accepted is not binding but what is binding is the commitment from the buyer to pay the seller for legitimate costs born from work carried out within the contract. The reimbursement includes both work and material costs and added to that is a payment that typically represents the seller’s profit, fee or award. These costs include, direct costs; costs that have been incurred solely for the purpose of the project and, indirect costs; costs that refer to more general costs such as administrative and general overhead costs.
Cost-reimbursable contracts often contain incentive-based contracts where the fee or award is based on a series of predetermined performance objectives, such as meeting a particular schedule or keeping the activity below a certain cost threshold. Depending on the type of contract the buyer and seller agree to; a target cost and incentives are calculated upfront. The types of cost-reimbursable contracts include:
- Cost Plus Fee (CPF) or Cost Plus Percentage of Costs (CPPC): In these types of contract the buyer has to pay for all the costs, and in addition, a variable percentage of the costs as a fee. For example; an estimate of work and materials is provided by the seller and a CPPC contract is agreed to include estimated costs plus a percentage of the costs of 10 percent. As the work is completed, depending on the payment terms of the contract, the seller charges all costs plus a 10 percent fee on top. This type contract is not widely used and careful monitoring of the seller, particularly their purchase decisions is required.
- Cost Plus Fixed Fee (CPFF): In this type of contract an estimate of costs is provided by the seller and then once agreed by the buyer a contract is finalized which includes a negotiated fixed fee that is usually a percentage of the estimated cost of the project. The buyer then reimburses the seller for all their costs during the project and pays the fee at the end of the project.
- Cost plus incentive fee (CPIF): In this type of contract a target cost is derived from the estimate of costs provided by the seller and in addition a target fee is agreed between both parties based on specific performance based criteria or KPIs. The buyer then reimburses the seller for all their costs during the project. At the end of the project, if the costs fall below the target cost, the seller gets a percentage of the savings; however if the costs are over the target costs then buyer shares the percentage of the overrun costs. This is measured by a ratio typically 80 percent to the buyer and 20 percent to the seller. As all the costs are covered by the buyer, it is the target fee that is adjusted based on the final costs. The target fee agreed upfront in the contract has a minimum and maximum limit so that the seller is protected to some degree with a minimum fee should the costs of the project overrun the agreed thresholds.
- Cost Plus Award Fee (CPAF): In this type of contract the estimate of work from the seller is agreed by the buyer together with a base fee plus an award fee or bonus amount based on specific performance criteria. This contract is similar to the CPIF contract with the exception that there is no penalty associated with the award fee. All costs and the base fee are paid by the buyer and the award fee is set to a maximum amount that acts as an incentive for the seller. For this type of contract to be fully effective, a governance board needs to be in place together with clearly defined KPIs than can be measured to ensure fair payment to the seller based on their performance.
In addition to competitive procurements, the below terms are used for noncompetitive procurements:
- Single source: used with prefered sellers with existing agreements in place and where there is no requirement to go through a full procurement process.
- Sole source: used when there is just one specialist or niche seller in the market available for the work to be carried out.
Depending on the product or service that is being purchased the project manager will choose the most appropriate SoW and contract type, and these together with the standard or specific terms and conditions will make up the contract.
The procurement department should hold standard contracts and the procurement manager with support of the project manager will tailor the contracts to meet the needs of the project objectives and requirements.
Defining the source selection criteria
The selection criteria must be documented in order to be able to rate or score the seller’s proposals; this criteria can be either objective or subjective.
Source selection criteria is often included as part of the procurement documents and can be limited just to price for commodity items where the item is already available from a number of sellers. For more complex proposals, it can include information on the supplier’s required capabilities, levels of risk, its management and technical approach, project management knowledge, delivery timelines, warranty periods, product and life-cycle costs, past performance and references.
The project manager will work closely with the procurement manager to prepare the procurement documents that will be sent out to the prospective sellers that describe the buyer’s requirements, how and when to respond together with the criteria the buyer will use to select the seller.
The plan procurement management process is now is completed and the next step is to execute the plan, starting with the conduct procurements process which includes; selecting and shortlisting the seller’s, running bid conferences, evaluation, seller meetings, presentation and negotiations…
IT Project Management
2 thoughts on “How to select the best type of contract for your project”
Excellent post. I was checking constantly this blog and I’m impressed! Very helpful information particularly the last part 🙂 I care for such information a lot. I was looking for this particular information for a long time. Thank you and best of luck.
Thank you, I will get into more details on pre-sales and be posting again soon…