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Contract Types: Fixed-Price and Cost-Reimbursement
Project Management · Chapter 7: Vendor Selection and Contract StructuresSection 7.3 · lesson 43 of 7313 min · free with a free account
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In this lesson
How fixed-price and cost-reimbursable contracts divide cost risk.
- Distinguish unilateral contracts from bilateral contracts
- Explain how fixed-price, cost-reimbursable and time and materials contracts allocate cost risk
- Calculate buyer payments under incentive fee, economic price adjustment and capped time and materials terms
- Choose a contract type using scope clarity, uncertainty, duration, oversight capacity and the seller's risk appetite
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Transcript
Everything said in the video, section by section (1,842 words). Read along, or search it.
Opening Case
Paying for Work Behind Unopened Walls
Hana is the sponsor at Eastfield Regional School District, renovating the Annex, an old classroom wing. The windows, floors and lighting are easy to describe. But the wiring and floor structure sit behind walls that have never been opened, so nobody knows how much repair they need. The school board wants one figure to approve, and the work must finish in one summer. How should Hana pay the contractor? The answer depends on who should carry the risk of what's behind those walls.
Key Terms
Contract Types, Unilateral and Bilateral
A contract type is the payment arrangement a contract uses. It decides how the seller is paid, and so who absorbs the difference when the work costs more or less than expected. This is general background, not legal advice. Contract law varies by jurisdiction and changes over time, so real contracts involve qualified counsel. First, a different distinction: how promises are exchanged. A unilateral contract is a promise honored once someone performs a requested act, while the other side promises nothing. A community radio station offers 200 to anyone who returns its lost recorder. Nobody has to search, and nothing is owed until someone returns it. A bilateral contract exchanges promises, so both sides are committed from the start. A cleaning firm promises a year of weekday cleaning, and a library promises a monthly fee. Most project supplier contracts are bilateral, because a schedule can't rest on a seller who hasn't committed.
Risk Allocation
Cost Risk and Specification Risk
Risk allocation assigns who bears the cost of uncertain events. Cost risk is the chance the work costs more or less than expected. Specification risk is the chance the description of the work proves incomplete, wrong, or changed. Two points always apply. Assigning a risk moves it without removing it: a seller asked to bear a risk it can't judge adds a margin, and the buyer pays it whether or not anything goes wrong. And a risk is usually best held by the party better able to influence it. The seller controls its crews. The buyer writes the specification. Contract types fall into two families. In the fixed-price family, the seller bears most of the cost risk. In the cost-reimbursable family, the buyer pays actual costs plus a fee, and bears most of it. Time and materials sits between.
Firm Fixed Price
One Price for Defined Work
Firm fixed price sets one price for a defined body of work, and the buyer pays it, whatever the work costs the seller. The seller holds the cost risk. It keeps every saving, and absorbs every overrun, so it has the strongest reason to control cost. The buyer holds the specification risk. If the description was incomplete, or the buyer later wants something different, the added work lies outside the price. With an unclear scope, the seller must guess, add a contingency, or price low and try to recover through changes. So firm fixed price suits clear, stable requirements.
Incentive Fee
Target Cost, Sharing Ratio and Ceiling
Fixed price with incentive fee lets the seller's fee rise or fall with actual cost, within a limit on what the buyer pays. Four terms define it. The target cost is the expected cost. The target fee is earned if cost hits target. The sharing ratio splits any difference, buyer share to seller share. And the price ceiling is the most the buyer will pay. Take a target cost of 400, a target fee of 40, a 70/30 split, and a ceiling of 470. If the actual cost is 360, that's 40 under target. The seller's 30 percent is 12, so its fee rises to 52, and the buyer pays 360 plus 52: 412. If the cost is 480, that's 80 over. The fee falls by 24, to 16, for 496. But the ceiling holds the payment at 470, and the seller loses 10. The ceiling starts to bind once cost passes about 443. Beyond that, the seller bears every extra unit, as if the price were firm.
Quick Check
Incentive Payment at a Cost of 230
Quick check, on a new incentive contract. Target cost 250, target fee 30, a 60/40 split, buyer to seller, and a ceiling of 290. The actual cost comes in at 230. What does the buyer pay: 268, 280, or 250? Pause and decide. 268. The cost is 20 under target. The seller's 40 percent is 8, so the fee is 38, and the buyer pays 230 plus 38. 280 is the target price, which ignores the saving, and 250 forgets the fee.
Price Adjustment
Letting an Index Move the Price
Fixed price with economic price adjustment lets the price move, up or down, when a specified outside condition changes, such as an agreed published price index for a key material. It suits long contracts in changing markets, where a seller holding a firm price would add a large margin, or decline. It moves one measurable uncertainty, the input price, to the buyer. Alder Foods buys packaging film for 30 months at a base price of 100 a unit, of which 40 is plastic. New price equals base price, plus the material portion times the index change. If the index rises 10 percent, the material portion rises by 4, and the price becomes 104. If the index falls to 5 percent below its starting level, the adjustment is minus 2, and the price is 98. The other 60 stays firm.
Cost-Reimbursable Family
Fixed, Incentive and Award Fees
In the cost-reimbursable family, the buyer pays the seller's actual costs, as the contract defines them, plus a fee. The buyer holds the cost risk, which suits work whose scope can't be defined well enough to price. The price of that is oversight. The buyer must confirm that claimed costs are real, qualify, and are reasonable, which takes records, access and staff time. Cost plus fixed fee pays cost plus a fee fixed at signing. The seller earns the same fee whether the work is cheap or dear, so it has little reason to economize. Oversight stands in for that missing motive. Cost plus incentive fee lets the fee vary with cost against a target, usually between a minimum and a maximum. The buyer still bears most of the cost risk; only the fee moves. Cost plus award fee adds an award, which the buyer grants by judging performance against criteria stated in the contract, like quality or responsiveness. Those criteria should be written before work begins.
Time and Materials
Hourly Rates With a Not-to-Exceed Cap
Time and materials pays an agreed rate per hour or day, times the time actually worked, plus materials at cost or an agreed markup. The rate includes overhead and profit, so there's no separate fee. It looks fixed-price, because the rates are fixed, and cost-reimbursable, because the total isn't known until the hours are used. The buyer bears the risk of how many hours are needed. At 11 an hour, 40 hours costs 440. Without a limit, the buyer's exposure is open-ended. A cap, or not-to-exceed amount, limits the total. With a cap of 460, the cap binds after about 41.8 hours, and hours beyond it become the seller's risk unless the parties agree otherwise.
Risk Spectrum
Seven Types From Buyer Risk to Seller Risk
Lay the seven types along a line, from the buyer bearing cost risk on the left, to the seller bearing it on the right. The cost-plus types sit on the left, time and materials in the middle, and the fixed-price types on the right, with firm fixed price at the end. Scope certainty tends to rise along the same line. When scope is unclear, a seller holding cost risk is pricing something nobody can yet describe, so types toward the left are chosen. This is a tendency, not a rule. A time and materials contract with a low cap sits nearer the fixed end. An incentive contract with a low ceiling behaves almost like a firm price. Read the actual terms.
Selection Factors
Five Factors Guide the Choice
Five factors guide the choice. Scope clarity: could two sellers price the same job from the description? Clear and stable points toward fixed price. Uncertainty: could cost move a lot, from unknowns nobody can estimate? That points toward cost-reimbursable, unless one measurable input can be handled by an adjustment. Duration: the longer the contract, the more can change. Oversight capacity: can the buyer actually check costs and hours? If not, a known price needs less checking. And the seller's appetite for risk: can it absorb an overrun, and at what price? When the factors disagree, the choice is a judgment about which risk the buyer would rather hold.
Worked Comparison
Four Types on One 440 Budget
Now compare four types on one job. The budget is 440: an estimated cost of 400 plus a fee of 40. Time and materials runs at 11 an hour, with a cap of 460, and the seller's own cost is 10 an hour. If the work actually costs 360, the buyer pays 440 under firm fixed price, and 412 under the incentive contract. It pays 400 under cost plus fixed fee, and 396 under time and materials. If it costs 480, the buyer pays 440, 470, 520, and 460, where the cap binds. The spread of the buyer's payment is nothing under firm fixed price, 58 under the incentive contract, 64 under capped time and materials, and 120 under cost plus fixed fee. The seller's result runs the other way: from a gain of 80 to a loss of 40 under firm fixed price, but a steady 40 under cost plus fixed fee. These are payment mechanics, not a forecast of which type costs less.
Quick Check
Research Scope Discovered as Work Proceeds
Quick check. A university buys research from a lab. The scope will only be discovered as the work goes, and the university has staff who can review cost claims. Which type fits best: cost plus fixed fee, firm fixed price, or fixed price with economic price adjustment? Pause and decide. Cost plus fixed fee. Nobody can price work that hasn't been defined, so the buyer holds the cost risk, and its review staff supply the cost discipline the fixed fee lacks. A firm price would force the lab to guess, or pile on contingency. And a price adjustment handles one measurable input, not an undefined scope.
Case Resolved
Hana Chooses Cost Plus Fixed Fee
Back to Hana. Firm fixed price would give the board its single figure. But contractors said they'd add a big contingency for what's behind the walls, one mentioned 18 percent, or exclude hidden conditions entirely. The first means paying for risks that may never happen. The second turns every surprise into a dispute. Cost plus fixed fee lets the contractor open the walls, and repair what it finds, without arguing about price. But her two-person facilities office must review cost records every month. She chose cost plus fixed fee, with a monthly cost review, and a contingency reserve in the board's budget. And she told the board to expect a range, not one figure. She traded price certainty for flexibility. The district holds the cost risk and the oversight work, and the monthly review does the economizing the fixed fee won't.
Key Takeaways
Who Absorbs Cost Surprises
To recap. Unilateral contracts trade a promise for an act, and bilateral ones trade promises. A contract type decides who absorbs cost surprises. Fixed price puts cost risk on the seller, and cost-reimbursable puts it on the buyer, who must then oversee costs. Choose by scope clarity, uncertainty, duration, oversight capacity, and the seller's appetite for risk.
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Project Management (Business 230) is a self-paced online course of 73 video lessons in 12 chapters, from starting and defining a project to planning, budgets, scheduling tools, proposals, contracts, execution, monitoring, closure, teams and certification. It carries a NCCRS credit recommendation for 3 semester credits.
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About Contract Types: Fixed-Price and Cost-Reimbursement
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