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Contract Types

5 minutes 5 Questions

Contract types determine the division of risk, cost, and responsibility between the purchasing organization and the supplier. Various contract types are employed in procurement projects, ranging from fixed-price contracts, where the price is agreed upon and set, to cost-reimbursable contracts, where the vendor is paid for their actual costs plus an agreed-upon fee, to time and materials contracts, where payments are based on the time the vendor spends on the project and the materials used. The chosen contract type will heavily influence the procurement planning process and should align with the project objectives, risks, and desired level of control over the vendor.

Guide: Contract Types in Procurement Planning

Contract Types are a crucial component in Project Management Procurement Planning as outlined in the PMBOK Guide Seventh Edition. Understanding contract types, their benefits, limitations and best time of application is essential.

Why it is important: Having detailed knowledge of contract types helps in choosing the most suitable one for different scenarios, which can influence project risk, cost, and control.
What it is: Contract types in Project Management are essentially agreements where terms and conditions are defined between the project organization and a vendor for the provision of specific services or products.
How it works: Contract types can be broadly categorized into Fixed Price, Cost Reimbursable and Time & Material Contracts. Each type has its own benefits, drawbacks, and rules.

Exam Tips: Answering Questions on Contract Types
1. Understand the key characteristics and differences between different contract types.
2. Be aware of the risks associated with different contract types.
3. Apply knowledge of contract types to different scenarios to choose the most suitable type.
4. Remember, there is usually a 'best' type of contract to use depending on the situation and conditions ppresented in the question.
5. Refresh knowledge on PMBOK Guide's stance on different contract types.

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PMP - Procurement Planning Example Questions

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Question 1

A construction company is awarded a contract to build a bridge within a fixed budget. The owner wants to encourage the company to complete the project ahead of schedule. Which contract type would be most appropriate?

Correct Answer: Fixed Price Incentive Fee (FPIF)

The Fixed Price Incentive Fee (FPIF) contract type would be most suitable in this situation. The reason is that this type of contract provides an incentive for the construction company to complete the project ahead of schedule while staying within the budget. This is achieved by setting a price ceiling and a target cost. If the actual cost is lower than the target cost, both the buyer and the contractor share the cost savings. This encourages efficiency and timely completion. On the contrary, Cost Plus Fixed Fee (CPFF) provides the contractor a guaranteed fee and doesn't incentivize the company to finish the project early. Cost Plus Incentive Fee (CPIF) can motivate the company to reduce cost overruns, but doesn't necessarily encourage early completion. Lastly, Fixed Price with Economic Price Adjustment (FP-EPA) adjusts the total price by specific financial indices but doesn't provide an incentive for early completion.

Question 2

Your organization won a contract to manufacture and deliver medical equipment to hospitals. The raw materials and labor costs are subject to market fluctuations. Which contract type would be most suitable?

Correct Answer: Fixed Price with Economic Price Adjustment (FP-EPA)

The best suitable contract type in this case would be a Fixed Price with Economic Price Adjustment (FP-EPA) contract. In this type of contract, the prices are adjusted based on well-defined market fluctuations in raw material and labor costs. This makes it ideal for situations like this, where there are unknowns related to the cost of materials and labor over time. Fixed Price (FP) contract does not account for market fluctuations and therefore is not the most suitable. Cost Plus Fixed Fee (CPFF) and Cost Plus Incentive Fee (CPIF) contracts would make the customer bear the risk of cost overruns and these types of contracts are not preferable when costs can be estimated with reasonable accuracy, which is the case with manufacturing and delivery of medical equipment.

Question 3

A company is hired to provide consulting services with no specific deliverables but must track hours worked and provide a detailed breakdown of work completed. Which contract type is most appropriate?

Correct Answer: Cost Plus Fixed Fee (CPFF)

The 'Cost Plus Fixed Fee (CPFF)' contract type is the most appropriate for a company hired to provide consulting services with no specific deliverables but must track hours worked and provide a detailed breakdown. It is because, in this type of contract, the buyer pays the seller for the seller’s allowable costs, plus a fixed fee which is usually calculated as a percentage of the estimated project costs. This contract type offers more flexibility and adaptability for consulting services where the scope of work may not be well-defined and hours will need to be tracked. The other options aren't suitable: 'Fixed Price (FP)' contract does not account for variable hours as it's a set price, 'Fixed Price with Economic Price Adjustment (FP-EPA)' is typically used when a contract spans multiple years, and 'Fixed Price Incentive Fee (FPIF)' is not applicable because it offers incentives based on meeting agreed upon metrics, which is not the case here.

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