Contracts--from the vendor and the buyer point of views
Contract management is a management science by itself. It has unique challenges and skill sets. Successful contract initiation and management is a major, critical success factor for projects. Many projects fail due to lack of knowledge, such as undefined scope and deliverables, and many project vendors are under-managed.
This presentation is an active discussion about contracts by two presenters representing the viewpoints of the buyer (the company) and the seller (the vendor). It covers the pros and cons of various types of contracts, definition of resources needed, reimbursable expenses, payment terms, and termination agreements. It covers the full lifecycle of contract engagement and management.
When the session is completed, the attendee will be able to define four types of contracts – Fixed Price (Lump Sum), Cost Reimbursable – Cost plus Fixed Fee, Cost Reimbursable – Cost Plus Incentive, and Time and Materials. Attendees will be able to recognize pros and cons from the seller’s viewpoint and the buyer’s viewpoint of each of those four types of contracts. The risk taker(s) are identified. Attendees will be able to negotiate and successfully manage a win-win contract using tools such as prototypes and phased projects. Lastly, attendees will understand the full lifecycle of contract engagement and management, including review points, project resources, termination, and other contract considerations.
A contract is “a mutually binding agreement that obligates the seller to provide the specified product or service or result and obligates the buyer to pay for it” (PMBOK® Guide, PMI, 2004, p. 157).
It is an enforceable agreement formed by two parties who agree to perform or refrain from performing some act now or in the future.
The purposes of contracts are to define obligations and expectations, limit or define potential liabilities, lay out payment terms, determine who bears business risks, and clarify roles and responsibilities. From the buyer’s standpoint, the contract ensures that the product/service is provided as expected, and from the seller’s standpoint, the contract ensures payment and successful contract closure.
Contracts have many components, only a few of which will be discussed in this presentation. Other components include: statement of work, schedule, period of performance, roles and responsibilities, pricing and payment, inflation adjustments, acceptance criteria, warranty, product support, limitation of liability, fees, retainers, penalties, incentives, insurance, performance bonds, subcontractor approval, change request handling, termination, and dispute resolution mechanism. Exhibit 1 shows the aspects of contracts covered in this presentation.
Before a company (the buyer) gets into a contract engagement, there is a lot of pre-work that needs to be done, such as Request for Proposal (RFP), Information for Bid (IFB) and Request for Quote (RFQ). For every step taken during the contract initiation and management process, we must make sure that company/organizational policies are followed and adhered to. Vendor management (vendor selection processes and procedures) includes common organizational policies related to contract management, vendor management, company information system and security management (including security standards and procedures).
Exhibit 1 – Presentation topics
In most cases, a contract is managed as a separate project or sub-project. Therefore normal project management-related processes and procedures apply here, including performance reporting and quality control. A contract needs to be formally closed when complete.
Let’s take a closer look at four types of contracts; (1) fixed price, (2) cost plus fixed fee, (3) cost plus incentive fee, and (4) time and materials.
Fixed Price Or Lump-Sum (FP) means a fixed total price for a well-defined product. If the product is not well defined, both parties are at risk—the buyer may not receive the desired product or the seller may incur additional costs to provide it. Fixed price contracts provide the buyer with defined cost without overruns, although the initial cost may be higher to account for risks and unknown factors. For the seller or vendor, the advantage of a fixed price contract is a well-defined product with definite scope and deliverables, although the seller does bear the risk of loss if costs overrun or if the project entails more details than originally anticipated (see Exhibit 2).
Exhibit 2 – Fixed price contracts
The next type of contract that we are going to look at is a Cost Reimbursable/Cost Plus a Fixed Fee (CPFF) contract, which is payment (reimbursement) to the seller for actual costs plus a profit. Types of costs include direct costs incurred for the exclusive benefit of the project (salaries of full-time staff), and indirect – overhead (generally calculated as a percentage of direct costs). This type of contract has the advantage for the buyer of no cost overruns on fee, just on materials, while, like a fixed price contract, it provides a higher initial cost but also has the risk of material overruns. For the vendor or seller, the advantage is again a well defined product, but with risk of loss which is limited to a loss on service only, not materials (see Exhibit 3).
Exhibit 3 – Cost plus fixed fee contracts
Cost Reimbursable, or Cost Plus Incentive Fee contracts means payment (reimbursement) to the seller for actual costs plus incentives for meeting or exceeding selected project objectives, such as schedule targets or total costs. This type of contract may help keep projects within budget and on time. The advantage to the buyer is that the incentives may help keep the project within budget, but the buyer also has the risk of exceeding expected costs. The seller or vendor gets a reward for staying within the budget or schedule but also bears the risk of not meeting that budget or schedule (see Exhibit 4).
Exhibit 4 – Cost plus incentive fee contracts
Time and Materials (T & M) contracts include the cost of supplies plus compensation for actual time spent at a fixed-price. It is an open-ended agreement for time and materials. Undefined costs may escalate into project overages with this type of contract. This type of contract is especially useful for projects where the scope is difficult to define and protects the seller from cost overruns, although the buyer will be the one bearing the risk of loss. One advantage is that vendor relations are generally better under this type of contract, provided project phases are put into place. Again, good scope definition and agreement is essential to a successful outcome (see Exhibit 5).
Exhibit 5 – Time and materials contracts
So, from the above contract definitions, you can see that the seller bears most of the risk with a fixed price contract, the buyer with a cost plus fixed fee contract, both share with the cost plus incentive and the buyer bears the risk with a time and materials contract (see Exhibit 6).
Exhibit 6 – Risks of contracts
Let’s talk about some other essential elements to contracts that can help create a win-win situation between buyers and sellers. Project scope must be clearly defined and include the length of project, project deadlines/milestones, deliverables definition/format, assumptions and constraints, performance monitoring and reporting, acceptance criteria, and items not included in scope, such as roles and responsibilities.
Breaking projects into phases can also help create win-win projects because it allows both parties to assess the situation and determine if things are on track and if the scope is still within definition. One advantage is that by closing out one phase before beginning the next, there is less risk for each party. Contract payment could also be tied to completion of phases. It provides the buyer with the flexibility of potentially changing vendors at the end of a phase or even terminating the project based on the results of a specific phase. Creating prototypes and samples also provides the advantage of client acceptance before continuing work. [AUTHOR: CHECK CHANGES]: Using industry best practices such as Rational Unified Process or Iterative Development Process can also assist in creating a mutually successful project.
Project review points and revisions also assist in creating successful projects. Determine the client review/revision schedule by phases and/or by milestones. Determine the agreed-upon performance monitoring and reporting process and schedule, as well as phase and project acceptance criteria.
Another important factor for success is the determination of project resources and support. Who is going to provide information and equipment? Who is the client representative or project manager responsible for authorizing and approving phase completion and milestones? Determine subject matter expert (SME) availability and other client resources availability as well as equipment and facilities and any information needed from client. Be clear about who is going to provide a laptop or office space. Make sure that required information is available as needed on a timely basis to avoid schedule and cost overruns.
Project termination is another issue that must be addressed in contracts. There must be a mutual agreement regarding project termination – termination responsibilities of each party must be stated, as well as product ownership (work for hire), the development of lessons learned documentation, and signoff and contract closure procedures. Other questions must be answered, such as: Can the project be terminated by either party? With or without notice? Will there be penalties for early termination? What about arbitration in the case of lawsuit?
Other contract considerations that are not covered in this presentation include confidentiality agreements, nondisclosure agreements, work-for-hire, non-compete agreements, dispute resolution/arbitration, assumptions and constraints, conflicts of interest, governing law, and adherence to corporate organizational policies.
Lee, W. (2004). Project management professional - A graphical study guide. Trafford Publishing, Victoria, BC Canada.
Project Management Institute. (2004). A guide to the project management body of knowledge (PMBOK® Guide – Third Edition). Newtown Square, PA: Project Management Institute.
©Lee Brannan, CPA, PMP and Wei Lee, PMP
Originally published as part of 2007 PMI Global Congress Proceedings – Atlanta, GA
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