Project Management Institute

Project contracts

a decision matrix approach

by Terry R. Adler and Robert F. Scherer

CONTRACTS ARE AN IMPORTANT part of the project manager's life. Consider how much time is devoted to managing make/buy decisions, assessing vendor requirements and responsibilities, or even monitoring in-house contracts between business divisions. One of the major decisions in developing a viable contract is the choice of contract type. While some contracts are definitive and specific, others are more open-ended, largely dependent on buyer and seller objectives and the nature of the work involved.

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Research and development is one set of activities in which the nature of the work spans both the definitive and open-ended varieties. For instance, in basic research, activities are conducted to advance technology. In applied R&D, technology is focused toward a specific solution. The contract type decision can enhance or detract from the achievement of R&D objectives depending on the nature of the work involved. For instance, if a contract stipulates that the seller in the contract will be reimbursed for necessary and reasonable costs, then it is difficult, if not impossible, in legal terms, to control additional costs. On the other hand, if the seller agrees to a firm price, regardless of subsequent project execution issues and problems, the seller is “on the hook” to perform and meet contractual obligations. While it is normally not this simple, the basic choice of contract type early in the R&D project identification and definition phases dramatically influences subsequent project execution and program success.

Unfortunately, many project managers tend to view project contracts as interchangeable, administrative necessities, and fail to appreciate the impact contract type has on the success of the project. The correct choice of contract type is a vital strategic decision that influences the monitoring and outcome of subsequent contract performance.

Basic Contract Types

A fundamental decision in project management is how to perform the project. If this entails outsourcing, joint ventures or strategic alliances, there will undoubtedly be contracts stipulating unique administrative and performance requirements. Contracts also differ by type with regard to how risk is distributed between the buyer and seller. Exhibit 1 lists the characteristics that influence project risk assessment and choice of contract type.

Contracts differ by type with regard to how the risk is distributed and how the project is performed. For example, if the project entails outsourcing, joint ventures or strategic alliances, there will undoubtedly be contracts stipulating unique administrative and performance requirements

Exhibit 1. Contracts differ by type with regard to how the risk is distributed and how the project is performed. For example, if the project entails outsourcing, joint ventures or strategic alliances, there will undoubtedly be contracts stipulating unique administrative and performance requirements.

Two criteria useful in the selection of a contract type are human asset specificity and contract impediments. Using these criteria, the project manager can develop a decision matrix, as shown here

Exhibit 2. Two criteria useful in the selection of a contract type are human asset specificity and contract impediments. Using these criteria, the project manager can develop a decision matrix, as shown here.

Fixed price or firm-fixed price (FFP) contracts put the total project risk on the seller. FFP contracts typically reflect known products and services that have multiple substitutes and adequate documentation. An example of when an FFP contract is recommended is in the applied R&D arena where innovations are translated into marketable items. In the software arena, when source code and documentation are adequate, an FFP contract would be appropriate for optimal performance.

Cost or cost-plus fixed fee (CPFF) contracts put the majority of risk on the buyer. R&D is typically in its infancy as characteristics of the products and services are under development. Buyers reimburse sellers for reasonable costs that further the development of these products and services, which makes the CPFF contract the appropriate choice in this situation.

An incentive contract is an intermediate contract type that shares R&D costs between buyer and seller. Both buyer and seller share in the risk of the R&D project. Transitional projects coming out of basic research and into the applied phase of the R&D life cycle are candidates most likely to use this contract type. Because project risk is difficult to identify and quantify, buyer and seller agree to share in managing unknown contingencies.

Commercial and government contracts likely reflect one of these three basic contract types. The correct choice of contract type should fit the characteristics of the project being considered. Mismatches between contract and project types hamper project managers in their flexibility to manage and monitor contract performance and also limit project execution.

Choosing Among Contract Types

Our work with R&D contracts has assisted us in identifying two criteria useful in the selection of a contract type: human asset specificity and contract impediments. Exhibit 2 provides a decision matrix for the project manager using these criteria.

Human asset specificity refers to the magnitude of labor required to fulfill the contract. The more human resources necessary to complete a project, the more likely the project reflects new design, development, or construction. FFP contracts require fewer human assets than CPFF contracts since FFP contracts are typically used for market-like items. Most of the unknowns associated with new development have already been discovered and resolved. Subsequent contract performance more closely matches project objectives, established before contract award, due to lower development risk and fewer contract changes. Thus, fewer human assets are needed to manage unknown project issues in FFP arrangements.

A contract impediment is defined as the requirement for continuing project integration. This criterion includes continual estimation of project plan development, execution and change control to address future contingencies once the contract is awarded.

The FFP Decision. The FFP contract type is beneficial for low-growth project integration requirements. Logic dictates that because R&D products and services are known, the seller assumes the remaining risk in providing project integration. The project manager in these kinds of projects is more of a monitor of project “workaround” up to the point in time when the seller needs to increase project scope. Of course, increasing project scope requires additional project integration and would require more project management involvement. A major tenet of project and contract management, however, is to eliminate scope creep or requirements growth. Where requirements can be identified before contract award, human asset specificity and contract impediments are projected as minimal and the FFP contract is the most appropriate type. Consequently, the project manager's role for FFP contracts is that of a monitor, as shown in Exhibit 3, which is characterized by low levels of involvement in resolving project/contract disconnects.

The CPFF Decision. CPFF contracts require the highest human asset specificity because much of the project work is unknown (see Exhibit 2). The lack of lessons learned, the early nature of the R&D work, and the focus of developing the technology and not a specific product or service requires greater quantities of human resources. These results should not lead to the conclusion, however, that projects using the CPFF arrangement will have relatively poorer cost, schedule, and technical performance than FFP contracts. In fact, CPFF may have better performance, if contract type matches the type of work being performed. It is the mismatch between project and contract types that leads to poor project execution and subsequent poor contract performance. Project managers need to identify the degree of human asset specificity required for a project and make subsequent decisions about contract types early. If sellers propose large doses of labor to fulfill your contract, if your contract is open-ended with many “not to exceeds” or “not separately priced” items, and your project covers early research activities, a CPFF-type contract is best suited for your project needs.

CPFF contracts have moderate contract impediments requirements. Since the project objective of CPFF work is to design, develop and construct new projects, contracts are typically established to address project change. The buyer assumes most of the risk since the buyer is on the hook for project cost and managing project uncertainty and change. The need for continual project reassessment, which leads to high human asset specificity, does not necessarily affect contract performance since the contract is organized to handle future change. Thus, CPFF contract types are most appropriate when human asset specificity is high but contract impediments are low, since the contract is organized to include change. Many firms employ CPFF contracts with the goal of translating new developments into new product development. The role of the project manager, as identified in Exhibit 3, is one of mentor, a high involvement role, to assist in the resolution of project management issues as they arise.

The Incentive Decision. Incentive contracts fall between FFP and CPFF with regard to human asset specificity. As illustrated in Exhibit 2, human asset specificity is moderate. Clearly, the need for project management oversight is mixed, depending on the type of work. Typical types of work include modifications to existing hardware and software, enhancements to older systems, and advanced followon work in applied research.

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The various types of contracts require differing levels of involvement from the project manager

Exhibit 3. The various types of contracts require differing levels of involvement from the project manager.

Incentive contracts, however, have the most extensive contract impediments and the greatest need for continuing project integration. Since incentive contracts entail extensive monitoring and response by both buyer and seller, these contract arrangements are associated with high-growth integration projects. In theory, FFP and CPFF contract types are at polar ends of the risk spectrum: seller risk is high in FFP contracts and buyer risk is high in CPFF contracts. However, incentive contracts may be risky to both buyer and seller, being both mutually beneficial and detrimental. The arrangement to share risk responsibility clouds project ownership and adds additional administrative contractual requirements that are not easily managed from the original contract. Not only does the project manager have to manage project development, he or she must also manage contract administration matters to address out-of-scope contract changes. Thus, for moderate levels of human asset specificity but high levels of project and contract integration, incentive contracts are the most appropriate form. The project manager's role in this type of contract is one of enforcer, reflecting the tension project manager's have in reacting to and fixing project and contract disconnects and issues.

Thus, the contract impediments selection criteria identifies that for low-to-moderate-growth project integration requirements, FFP and CPFF contracts, respectively, are the most appropriate contract types to use. On the other hand, if the potential growth in project integration requirements is high, then incentive-type contracts would be the most suitable. The maxim is, Don't increase the scope of the contract (i.e., project) by using an inappropriate contract type.

Reader Service Number 5095

Here are four basic principles for selecting an appropriate contract type:

Project success is a function of project and contract performance.

The analysis of human asset requirements and contract impediments by contract type provides benefits. Expect to spend some time analyzing human resource requirements and contract impediments before deciding on the most optimal contract form.

Contract type determinations should be done early in the project planning process, before contract formulation and execution. The worst possible scenario is to make the correct contract type decision ex post facto.

Contract type decisions can affect the amount of work required to complete the project if the contract does not allow project managers the flexibility to manage the project. Being shackled with an inappropriate contract type makes it difficult to effectively manage projects over the life of the project.

Improved Understanding of Contract Requirements

The trend to contract out, out-source, and privatize R&D is growing. For example, Xerox Corporation's PARC lab demands detailed contracts with its own product divisions before starting or continuing research. Contracting out product development, production and service are not just peculiar to R&D though. Many other “traditional” business activities are being contracted out, which makes the two contract selection criteria (human asset specificity and contract impediments) applicable to a wide range of projects. We can assume that all contracts are the same and find our flexibility to respond to future change limited, or we can more adequately select contract forms that reflect the work to be performed. The choice of contract type does matter.

PROJECT MANAGERS NEED to analyze how contract type decisions are made within their organizations. A key benefit of these analyses will be an increased sensitivity to how human asset requirements differ by the type of contract employed. An additional benefit will be an enhanced appreciation for the type of contract impediments that affect project performance. The net result of this approach to contract selection will be better overall understanding of the project and contract relationship—two separate activities—associated with project performance. ■

Terry R. Adler, Ph.D., is assistant professor of systems management in the Faculty of Graduate Acquisition Management at the Air Force Institute of Technology, Wright-Patterson Air Force Base, Ohio. He has published in journals such as American Business Review, Journal of Business and Behavioral Sciences, and IEEE Systems Journal.

Robert F. Scherer, Ph.D., is associate dean of community relations in the College of Business and Administration at Wright State University. He has been published widely on the topics of business education, performance, occupational stress, entrepreneurship and gender in the workplace.

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This material has been reproduced with the permission of the copyright owner. Unauthorized reproduction of this material is strictly prohibited. For permission to reproduce this material, please contact PMI.

PM Network • July 1998

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