There are two major types of contracts: fixed-price contracts and cost-reimbursement contracts. These two types represent two extremes of risk sharing. In the case of fixed-price contracts, the seller bears the entire risk.
For the given fixed price, he/she is required to execute the contract irrespective of any events like cost escalations that may occur during the contract period. In cost reimbursement contracts, the buyer bears the entire risk. Here, the buyer needs to reimburse all the costs incurred towards executing the contract.
Between these two types, there are several other types of contracts, depending on the risk-sharing mechanism.
Table of Content
- 1 What is Fixed Price Contracts?
- 2 What is Cost Reimbursement Contracts?
What is Fixed Price Contracts?
Fixed price contracts are a type of contract used in procurement that establishes a predetermined, fixed price for goods or services to be delivered by a supplier to a buyer. Under a fixed price contract, the price is agreed upon upfront and does not change, regardless of any changes in the cost of materials or labor during the contract period.
Fixed price contracts allow the buyer to know the amount to be paid as per the budgetary allocation for the product purchase. The supplier has to carefully forecast costs as best as possible to avoid bearing undue risks. Normally, the supplier will include a contingency allowance as part of the fixed price quoted in the contract to take care of uncertainties.
The contingency allowance could be high enough to take care of an unpredictable increase in costs. This is the additional price the buyer pays for transferring the risk to the seller. The buyer should also carefully evaluate the fixed price quoted by the supplier as the contingency allowance might have been kept at a minimum to win the contract but the supplier may cut corners later to avoid losing money on the contract.
Fixed price contracts are generally applicable when costs are predictable and economic conditions are stable. In inflationary conditions, fixed price contracts may not be to the advantage of buyers even if sellers are willing to sign them.
Types of Fixed Price Contracts
There are different types of fixed-price contracts where prices are agreed to in advance of the contract execution. These contracts are:
Firm Fixed Price
This type of contract provides a price that normally is not subjected to any adjustment. However, prices are subject to change if they are explicitly involved in the agreement. The changes may relate to contract change, economic pricing, or defective pricing. In such type of contract, the risk of profit or loss is borne solely by the supplier.
Fixed Price with Incentive
This contract provides an incentive to the supplier for bringing down the cost. A profit formula is used based on the target cost and the target profit within an agreed-upon maximum price.
Suppose the contract establishes a target cost of ₹1,00,000 with a target profit of ₹20,000. The profit formula provides a sharing ratio of overruns and under-runs at 60% buyer and 40% supplier. If the actual cost at the end of the performance of the contract is ₹1,10,000, then there is a cost over-run of ₹10,000.
This additional cost will be shared between the buyer and the supplier at the ratio of 6:4. This implies the supplier profit will be reduced by 40% of 10,000, i.e. his/her profit will be ₹16,000 instead of the target profit of ₹20,000.
The net amount payable by the buyer will be ₹1,26,000 which is more than the targeted overall cost plus profit fee of ₹1,20,000 but less than what it would have been had it been a cost-reimbursement contract, i.e. less than ₹1,30,000.
Fixed Price With Economic Price Adjustment
This fixed price contract allows price adjustment instead of firm pricing. The contract will provide for established contingencies, such as escalating material and labor costs.
Any changes in costs beyond the supplier’s control (or ability to foresee) above or below the contract’s baseline can lead to an adjustment reflected in the supplier’s pricing. This type of fixed price contract is suitable for multi-year contracts or when there exist economic uncertainties.
In most fixed-price contracts, the clauses allowing escalation or de-escalation of prices are normally included. Firm fixed price contracts are not frequently encountered when cost variables are uncertain.
Fixed Price With Price Re-determination
This contract provides for price re-determination when costs are expected to change over the contract period. The specific time for redetermination will be part of the contract clauses.
Fixed Price, Level of Effort
When a fixed price cannot be determined for the contract owing to uncertainty regarding the amount of time or labor required, parties can agree on a standard level of effort and a given price. This contract is similar to a time and materials contract.
What is Cost Reimbursement Contracts?
Cost reimbursement contracts are a type of contract used in procurement that allows the buyer to reimburse the supplier for all costs associated with the project, including labor, materials, and overhead expenses, as well as an additional fee or profit margin. Unlike fixed price contracts, the final price is not known at the beginning of the project, and the total cost is determined at the end of the project based on the actual costs incurred by the supplier.
These contracts are used in cases when the total cost is difficult to predict (e.g. research and development work), risks are high, and the project requires close control and monitoring.
These contracts are meant to assure the supplier that the buyer will cover, at a minimum, agreed-upon costs subject to a monetary ceiling. The supplier is not expected to exceed that amount without prior approval.
Types of Cost Reimbursement Contracts
Various types of cost reimbursement contracts are discussed as follows:
Cost Plus Fixed Fee
In this type of contract, the supplier is entitled to a fixed fee in addition to the reimbursement of the normal expenses. In other words, cost-plus-fixed-fee contract allows the supplier to get reimbursement of all costs incurred plus a fixed profit fee, negotiated as part of the contract terms.
Cost Plus Incentive Fee
This is also a cost-reimbursement contract that provides an incentive to the supplier for bringing down overall costs. The supplier, in addition to the reimbursement of the normal expenses, gets an incentive, as part of the contract terms. This contract is similar to the fixed price with incentive contracts regarding the feature of sharing the cost savings based on an agreed formula.
Cost Plus Award Fee
This contract allows for a financial award in addition to the cost and negotiated fee, if the supplier achieves excellent results. The objective is to provide incentives to the supplier for achieving superlative performance.