What You Should Know about Fixed Price Contracts for the PMP Certification Exam
For the PMP Certification Exam, you should know that fixed price contracts are favored when the scope of the project is clearly defined and is not subject to change. With this type of contract, the seller is required to finish the work, regardless of the final price. Therefore, the majority of the cost risk is on the seller. There are several types of fixed price contracts.
Fixed price contract. A type of contract that sets a fixed total price for a defined product or service to be provided. Fixed price contracts may also incorporate 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.
Firm fixed price (FFP) contract. A type of fixed price contract where the buyer pays the seller a set amount (as defined by the contract), regardless of the seller’s costs.
Fixed price incentive fee (FPIF) contract. A type of contract where the buyer pays the seller a set amount (as defined by the contract), and the seller can earn an additional amount if the seller meets defined performance criteria.
Fixed price with economic price adjustment (FP-EPA) contract. A type of contract that is used when the seller’s performance period spans a considerable period of years. It is a fixed price contract with a provision allowing for predefined final adjustments to the contract price due to changing conditions, such as cost increases. The EPA clause must relate to a reliable financial index that is used to adjust the final price.
In procurement jargon, the word fee is synonymous with profit. The fee is what the seller receives after all the costs have been paid. A fixed fee remains the same regardless of the level of performance on the contract. Fixed fees usually are used on cost-reimbursable contracts.
Incentive fees can be used to stimulate performance on schedule, technical, quality, cost, or other types of performance. They can be used to motivate the seller to deliver early or to reach performance or quality standards. Award fees are based on a broad set of subjective criteria. They are used on cost-reimbursable contracts.
Firm fixed price
Most buyers prefer a firm fixed price contract because they know the price upfront. The buyer and the seller agree on a price for the work. The price remains the same unless there is a scope change. All risk for cost growth is on the seller. However, this isn’t always the best choice, particularly if the project scope is still evolving or subject to change.
Fixed price incentive fee
Fixed price incentive fee (FPIF) contracts establish a price ceiling and build in an incentive fee (profit) for cost, schedule, or technical achievement. The term “fixed price” can be misleading.
When the buyer is incentivizing cost performance, the buyer and seller establish a cost target, a target fee, and a share ratio, such as 80/20, 70/30, or something similar. Cost performance below the target cost earns an incentive fee. Cost performance above the target cost means the seller relinquishes some of the target fee.
When a contract has a share ratio for an incentive fee, the first number is what the buyer keeps, and the second number is what the seller keeps. Both numbers must total 100%. A 70/30 share ratio means that if the actual cost comes in under-target by $20,000, the buyer keeps $14,000 (70% of 20,000), and the seller gets the remaining $6,000.
Here’s an example. Say you have a contract with a target cost of $400,000, a price ceiling of $460,000, a target fee of $40,000, and an 80/20 share ratio. In this case, the price ceiling is the fixed price part. Regardless of the total cost, the buyer won’t pay more than $460,000
However, if the seller delivers the scope for less than $400,000 (target price), the seller gets the target fee of $40,000 plus 20% of the amount less than $400,000. However, if the cost is greater than $400,000, the $40,000 fee is reduced by 20% of the amount over $400,000.
See how this plays out if the actual cost is $425,000.The incentive fee would be calculated as follows:
((Target cost – actual cost) x share ratio) + target fee
((400,000 – 425,000) x .2) + 40,000
(–25,000 x .2) + 40,000 = 35,000
Therefore, the total price of the contract would be
$425,000 + $35,000 = $460,000
In this case, the price came in right at the ceiling. If the actual price had been more, the ceiling would have stayed at $460,000, and the seller would have started to lose some of his fee. The point at which the seller hits the dollar amount where he has to give back some of the fee is the point of total assumption.
This concept of the point of total assumption is something that started showing up on the PMP exam a few years ago. It is not in the PMBOK Guide. Likely, only one or two questions mention it. It is found only on FPIF contracts.