PMP Study: 3 Types of Contracts in Project Management

Types of Contract

In this article, we’ll define the three basic contract types and provide examples to help you understand when you’d use each of them.

1. Fixed Price Contract (FP)
2. Time and Material Contract (T&M)
3. Cost Reimbursable Contract (CR)

Fixed Price Contracts

These are also known as Lump Sum contracts. The seller and the buyer agree on a fixed price for the project. The seller often accepts a high level of risk in this type of contract. The buyer is in the least risk category since the price the seller agreed to is fixed. Be sure this type of contract has fully detailed specifications, checklists, and project scope statements from the seller's side, which the buyer will use.

With this type of contract, sellers may try to cut the scope to deliver the projects on time and within budget. If the project is finished on time with the desired quality, the project is over for that contract. However, if the project is delayed and there are cost overruns, then the seller will absorb all the extra costs. 

Below are a few types of fixed-price contracts:

• Fixed Price Incentive Fee (FPIF)

  Although the price is fixed, the seller is offered a performance-based incentive. The incentive can be dependent upon one or more project metrics such as performance, cost, or time.

• Fixed Price Award Fee (FPAF)

  If the performance of the seller exceeds expectations, an additional amount (i.e., 10% of the total price) will be paid to the seller.

• Fixed Price Economic Price Adjustment (FPEPA)

  The fixed price can be re-determined depending on the market pricing rate.

Cost Reimbursable Contracts

What do you do when the scope of the work is not clear? A fixed-price contract is out of the question since you are not sure what the project will require. Here’s where you’d use a cost-reimbursable contract.

A cost-reimbursable contract—also known as a cost disbursable contract—is used when the project scope is uncertain, or the project is high risk. The buyer pays all costs, so the buyer bears all the risk. Under a cost-reimbursable contract, the seller works for a fixed time period and raises the bill after finishing the work—a fee that represents the profits for the contract. The fee may be dependent on selected project performance or other metrics.

A major drawback of this type of contract is that the seller can raise an unlimited or unknown amount which the buyer is compelled to pay. This is why cost reimbursable contracts are rarely used. Below are a few types of cost-reimbursable contracts:

• Cost Plus Fee (CPF) or Cost Plus Percentage of Costs (CPPC)

  The seller will get the total cost they incurred during the project plus a percentage of the fee over cost; this is always beneficial for the seller.

• Cost Plus Fixed Fee (CPFF)

  The seller is paid a fixed amount that is agreed upon before work commences. The cost incurred on the project is reimbursed on top of this, regardless of project performance.

• Cost Plus Incentive Fee (CPIF)

  A performance-based incentive fee will be paid to the seller over and above the actual cost they have incurred on the projects. With this type of contract, the incentive is a motivating factor for the seller to meet or exceed the project’s performance metrics.

• Cost Plus Award Fee (CPAF)

  The seller will get a bonus amount (the award fee) plus the actual cost incurred on the projects; this type of contract is very similar to a CPIF contract.

Time and Material Contracts or Unit Price Contracts

Unit price contracts are what we usually call hourly rate contracts. This type of contract is a hybrid of a cost-reimbursable and fixed-price contract. For example, if the seller spends 1,200 hours on a project at $100 an hour, the seller will be paid $120,000 by the buyer. This type of contract is common for freelancers, and the main advantage of this contract type is that the seller makes money for every hour spent working on the project.

What are the Elements of a Legally Binding Contract in Project Management?

The elements of a legally binding contract in project management are the same as those for any other type of contract. However, in the context of project management, additional elements may be specific to the nature of the project being undertaken. Here are some of the critical elements of a legally binding contract in project management:

1. Scope of Work: The scope of work defines the specific tasks or deliverables expected to be completed under the contract. It should be clearly defined and agreed upon by both parties.
2. Project Timeline: The timeline specifies the start and end dates of the project, as well as any critical milestones along the way. It should be realistic and achievable.
3. Payment Terms: The terms outline the amount and timing of payments made to the contractor for their work. It should be unambiguous.
4. Change Management: The change management process outlines how changes to the scope, timeline, or budget of the project will be managed. Both parties should agree upon it.
5. Risk Management: The risk management plan outlines how risks associated with the project will be identified, assessed, and mitigated. It should be regularly reviewed and updated.
6. Confidentiality and Intellectual Property: The contract should include provisions to protect the confidentiality of project-related information and any intellectual property developed during the project.
7. Termination: The contract should include provisions for termination, including the conditions under which either party can terminate the contract.

All of these elements are critical to a legally binding contract in project management. By ensuring that they are clearly defined and agreed upon by both parties, the contract can ensure that the project is completed successfully and to the satisfaction of all parties involved.

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Conclusion

As Project Manager, it is your responsibility to enter into the right kinds of contracts with a variety of service providers to reduce risk and deliver the project on time. You should always consider the right type of contract to provide optimum value for the time and money spent on the project while protecting it from as many risks as possible.

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FAQs

1. What is a project contract?

A project contract is a legal agreement that outlines the terms and conditions of a project. It specifies the scope, timeline, budget, and deliverables, as well as the roles and responsibilities of each party involved. It serves as a formal agreement that ensures that all parties involved in the project are on the same page.

2. What are the 3 main types of contract in project management? 

The 3 main types of contract in project management are:

1. Fixed-price contract: A contract where the price is predetermined and fixed, regardless of the actual costs incurred during the project.
2. Time and materials contract: A contract where the price is based on the actual time and materials used during the project.
3. Cost-reimbursable contract: A contract where the buyer reimburses the seller for all the costs incurred during the project, plus a predetermined fee or profit margin.

3. Why are contracts important in project management?

The contract types in  project management are used to manage different levels of risk and uncertainty, and the choice of contract type will depend on the specific needs of the project and the preferences of the parties involved.

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