Contracts can be configured in various ways, but most are divided into one of two
categories: fixed price contracts (also called lump sum contracts) and cost plus
contracts (also called cost reimbursable contracts). Following is a summary
differentiating the characteristics of these two contract modes:
Fixed price contracts. Sellers agree to provide well-defined goods and/or
services by a specific date at a fixed price. Sellers bear most of the risk on this
contract, because if there is a cost overrun, the seller must assume the burden of
the loss. Fixed price contracts also have “opportunities,” because if the seller’s
costs are very low, they have an opportunity to increase their profits.
Cost plus contracts. Buyers agree to reimburse sellers for whatever costs they
incur in carrying out the contracted work. Clearly, buyers face a serious risk of
cost overruns here, because if contractors spend too much, buyers are obliged to
reimburse them. In order to create incentives for buyers to save money, some
variations on cost plus contracts have emerged, including: cost plus incentive fee contracts (CPIF). With the CPIF contract, a table is
created that shows how contractors can be paid defined bonuses if they
deliver their products early (e.g., $5,000 bonus if delivered one week
early; $8,000 bonus if delivered two weeks early).
cost plus award fee contracts (CPAF). With the CPAF contract, a pool of
award fee money (i.e., a bonus pool) is created. If contractors do a great
job on their contracts, an award fee panel may elect to pay them a bonus
with money taken from the award fee pool of money. Judgments of
performance are subjective.
cost plus fixed fee (CPFF). With CPFF contract, buyer and seller
negotiate a fee (i.e., profit amount) that the buyer will pay the contractor,
given that work is completed in a satisfactory manner. The fee is
negotiated before any work has begun. Thus contractors know ahead of
time what their profit levels will be. They have no incentive to increase
costs in hopes that that will lead to higher profit levels. CPFF contracts
are the dominant contract mode for research and development projects,
which are high risks efforts. A commonly employed variant of the cost plus contract is the time and materials
contract. This is a cost reimbursable contract where contractors are reimbursed
for the time they put into a job plus expenses they incur in purchasing materials.
Unlike the cost plus contracts, there is no explicit “plus” associated with the
contract. This does not mean profits cannot be gained. If profits are factored
into this type of contract, they must be built into the salaries and material costs
associated with performing the contract. 1 Assignment
1. For the following types of undertakings, which contract modes are most
appropriate? Be prepared to explain the rationale behind your choice. We want to order a pencil manufacturer to produce 20,000 pencils for
us We want to have a 300 meter bridge built to span a local river We want to have a contractor design a brand new circuit board that
has state-of-the-art capabilities We want to contract out work to operate our small factory 2. Describe the relative benefits and weaknesses of a CPIF contract vs. a
CPAF contract. 2 Single spaced 2 pages.
