To talk about contract types with a development company, we must evaluate the risks involved. The traditional concept of risk is that it is always negative; not the same from a PM point of view. Whenever you see the word “risk” , we should substitute it with “uncertainty” to eliminate the confusion created by the traditional definition. Contracts are established to manage and mitigate risk on both sides of the table. When a Buyer and Seller enter into agreement, there is both known and unknown risks associated with the procurement of products and services. In the IT world, there are commonly used agreements, but overall there are only a handful of commonly used contract types:
1. Firm Fixed Price Contract (Seller’s maximum risk)
2. Fixed Price Incentive Fee Contract
3. Time and Materials Contract
4. Cost Plus Incentive Fee Contract
5. Cost Plus Fixed Fee Contract (Buyer’s maximum risk)
Fixed Price Contract:
The two most important factors of a contract are the price and the scope of work; the price hits the buyer, whereas the scope of work hits the seller. Since the price is fixed in the fixed price contract, the “uncertainty” is not with the price, so the buyer has no uncertainty on its part.
Cost Reimbursable Contract:
In cost reimbursable arrangement, all the price of work complete is invoiced to the buyer. The total cost of the arrangement is always uncertain to the buyer till the job is complete. So the cost reimbursable contracts are more risky for the buyers.
Time and Materials Contract:
Time and Material is a hybrid type of contractual arrangement that contain the aspects of both cost-reimbursable and fixed-price contracts, so the risk is balanced between the buyer and the seller.
Firm Fixed Price Contracts (FFP):
In Firm Fixed Price Contracts, the margin(fee) is fixed. Any change in effort or work will directly hit the seller. The seller’s risk is at maximum over here.
Fixed Price Incentive Fee Contracts (FPIF):
Although the price is fixed, the seller’s margin is a bit variable. The seller will be rewarded by a higher margin based on the performance. Still since the price is fixed, the seller is at risk (it’s a fixed price contract after all) but in comparison with the firm fixed price contracts, the risk is lower for the seller.
Cost Plus Fixed Fee Contracts (CPFF):
The risk for the buyer is maximum over here since all the costs will be reimbursed plus a “fixed” fee will be paid to the seller regardless of the performance.
Cost Plus Incentive Fee Contracts (CPIF):
Although all the costs will be reimbursed to the seller, the seller’s fee (or margin) will be determined by the performance. This places a slight control over the arrangement. Again, since it’s a cost reimbursable contract, the risk lies with the buyer.
In conclusion, the merits of each contract allow vendors and buyers, to meet on a level playing field when it comes to the way they enter into an agreement and manage the risk of those agreements. Its no pleasure to come up short from either side; these methods mentioned allow for provisions to keep both sides honest in their commitments.