Fixed-price contracts

Developed by Tobias Nielsen

Abstract

Project management is the planning, delegating, monitoring, and control of all the aspects of the project. The first aspect involved in any project is the cost and agreements. In projects, agreements take the form of contracts.

A Fixed-Price Contract (also referred to as a lump-sum contract) is a contract that involves setting a fixed price for a well-defined product or service. The agreed-upon price from clients and suppliers for the service is unchanged throughout the project. If the project takes more time uses more materials or labor than first estimated, the price stays the same.

Projects with a fixed-price contract have a higher risk/reward profile. The risk in these projects is more significant for the supplier than in other projects, but in exchange for more reward if the project is an accurate offer and the project is well managed.

The supplier can't renegotiate the price when a project runs under a fixed-price contract. If something takes more man-hours or requires more material than expected, the supplier will have to deal with this extra cost themselves.

A fixed-price contract is often used when dealing with a repeated process. For example, a project manager will use the fixed-price contract in a construction project, where the project will be done repeatedly, or the project's scope is very clear.

Big idea

A project manager's role is to manage a project. Project management is the planning, delegating, monitoring, and control of all the aspects of the project. Project management is also the motivation of those involved in the project. This is done to achieve the project objectives within the expected performance targets. There are six aspects/variables involved in any project, and therefore six project performances to be managed. These aspects/variables are cost, timescales, quality, scope, benefits, and risk.

The first aspect involved in any project is the cost and agreements. In projects, agreements take the form of contracts. A contract is a binding agreement between the supplier to provide the specified product, service, or result and the client to pay for the service. A project manager can use different types of contracts; some are listed here.

- Fixed-price contracts: This contract involves setting a fixed price for a well-defined product or service.

- Cost-reimbursable contracts: This contract involves payments to the supplier for completing the work plus a fee representing supplier profit. This kind of contract is often used when the project scope is not that well defined.

- Time and materials (T&M): This contract establishes a fixed hourly rate but not a precise statement of work. It can be used for staff or other outside support. This type of contract is appropriate when the scope is less well-defined or could change during the project.

- Indefinite delivery indefinite quantity (IDIQ): This contract provides an indefinite quantity of services, with a lower and upper limit and a fixed time period. This kind of contract is often used for architectural, engineering, or information engagements.

Fixed-Price Contract

A fixed-price contract is a contract that involves setting a fixed price for a well-defined product or service. The agreed-upon price from clients and suppliers for the service is unchanged throughout the project. If the project takes more time uses more materials or labor than first estimated, the price stays the same.

Therefore, it is essential for the supplier to be very accurate when defining their offer for the scope of work. Once the offer is determined, it is shared with the client, and if the client agrees with the price for the work, it is final, and no change in man-hours or cost of materials can be considered.

The supplier can't renegotiate the price when a project runs under a fixed-price contract. If something takes more man-hours or requires more material than expected, the supplier will have to deal with this extra cost themselves. The supplier can communicate with the client for a price change, but the client is under no obligation to do so. If the client changes the scope of work, the supplier can expect a difference in the contracted price.

Figure 1: Contract risk : Source:[

Projects with a fixed-price contract have a higher risk/reward profile. The risk in these projects is more significant for the supplier than in other projects, but in exchange for more reward if the project is an accurate offer and the project is well managed. The project manager in such projects needs to remind the client that if they want a difference or a change in the scope of work, it requires a contract modification. The project manager should also have a project team that understands projects running under fixed-price contracts.

As shown in figure 1, fixed-price contracts have the highest risk for the supplier and the lowest risk for the client. It is also shown that the time and materials contract has the same high/low risk for both the supplier and the client. At last, it is shown that a cost-based contract has the lowest risk for the supplier and the highest risk for the client. Therefore it is essential for the project manager to manage the six aspects involved in the project and have discipline when running a project under fixed-price contracts.

Basic Elements that are included in a Fixed-Price Contract

What is in a fixed-price contract, and how is the contract buildup.

A Fixed-Price contract has similar construction and components to a contract that outlines work and payment. In general, a fixed-price contract includes and is constructed in the following basic elements.

Project Information:

• Owner: The person or organization that is hiring the supplier for the project.

• Supplier: The person that is offering for the work.

• Worksite: The site address for where the construction will take place.

• Scope of Work: Detailed and well-defined product or service of what the supplier will provide, project plans, schedule, specifications, etc.

• Price and Payment: Total price for the service, which is fixed and unchangeable throughout the project, how and when the client will make payments to the supplier.

Supporting Documents and Costs:

• Documentation: Construction drawings, blueprints, exhibits, etc., need to be included in the contract.

• Materials and Labor: List of materials and the labor employed to execute the project.

• Start and End Dates: The schedule includes the starting and completion dates, milestones, and other important dates.

• Licensing and Permits: Responsible for the permits and licenses required for the construction project.

Tasks:

• Subcontractors: Third-party vendors or subcontractors are listed and how they will be incorporated into the project.

• Work Changes: Identify how work change requests are processed throughout the project.

• Warranties: Warranties of the work, the supplier warrants the work, and material defects.

Closure:

• Termination: When the supplier can end the contract.

• Inspection: Inspection of the work to make sure it conforms to the contract.

• Insurance: Insurance obtained by client and supplier protects against damage, claims, etc.

• Liquidated Damages: The agreed-upon sum the supplier will pay the client for each day the project goes over the contracted deadline.

• Force Majeure: The client or the supplier is not responsible for events that occur due to circumstances beyond their control, such as weather, supply shortages, Corona, etc.

Figure 2: Fixed-Price Contracts buildup : Source:

Fixed-Price Contracts buildup

As shown in figure 2, the client's and supplier's standpoint of a typical buildup of the price for a fixed-price contract and project.

Supplier's standpoint:

The total expected cost of a fixed-price project consists of two parts:

(1) The base cost estimate estimates the total planned/budgeted project cost.

(2) The cost estimated for a contingency reserve allows additional activities like more man-hours or more material required than expected in the planned base cost estimate.

The total expected profit of a fixed-price project also consists of two parts:

(1) The cost estimated for a management reserve is to be used in an emergency situation if any unforeseen activities and risks occur.

(2) The appropriate cost is estimated for the project's profit, which considers market conditions, level of competition, strategic considerations, and other factors.

Client's standpoint:

The client receives the total price from the supplier and agrees with the price for the work if satisfied.

Types of Fixed-Price Contracts

Governments prefer fixed-price contracts. A fixed-price contract minimizes the risk for the government and maximizes value for the taxpayers. With an unchanged set price for the project, the supplier will control their costs to accomplish the project for the set price.

There are different types of fixed-price contracts; some of them are listed here.

Firm Fixed-Price Contracts: Firm fixed-price contracts give the supplier little or no work change. These contracts cannot be adjusted, and the supplier must complete the project for the set price. The supplier agrees to the profit or loss during the project.

Fixed-Price Incentive Contracts: Fixed-price incentive contracts is a contract where a formula is used to determine profit. A fixed-price incentive contract uses the project's final price and compares it to the target price of the project to adjust the profit.

Fixed-Price Contracts with Economic Price Adjustment: Fixed-price contracts with economic price adjustment give the supplier an insurance policy. The set price of the project can be adjusted up or down. For example, if corona/covid 19 is responsible for material costs going through the roof, the contract set price amount can increase to cover the increased materials costs.

Fixed-Ceiling-Price Contracts with Price Redetermination: There are two types of price redetermination contracts; prospective and retrospective. The prospective and retrospective contracts have a ceiling price established at the beginning of the project. The ceiling price is the most the client is willing to pay for the work. With a prospective redetermination contract, the price can be adjusted at specified times throughout the project. With a retrospective redetermination contract, the price can be adjusted after completing the project.

Application

A fixed-price contract is often used when dealing with a repeated process. For example, a project manager will use the fixed-price contract in a construction project, where the project will be done repeatedly, or the project's scope is very clear.

A quote from ProjectManager.com, When should a fixed-price contract be used. "A fixed-price contract is ideal when the requirements are clear and the deadline is set. They tend to be used in projects like the construction of buildings with a limited scope and fewer variables that can impact the schedule, labor, materials, and overall costs."

Implementing fixed-price contract

Implementing a fixed-price contract into a new project, and to succeed at fixed-price contracts and projects, the project managers should employ project management rigor and discipline, more than time and materials or cost-based projects.

These next steps guide a project manager to successfully implement fixed-price contracts into a new project and manage the project.

• Define the scope: Work with the client in a "joint venture" way to develop the project scope, objectives, deliverables, product, service, or result. Ensure that the estimate or contract document's basis clearly defines what constitutes the completed and accepted deliverables or service.

• Develop a work breakdown structure (WBS): A WBS is a hierarchical decomposition of the work in the project, helping the project manager to see both the individual components and the totality of the work that needs to be done in the project. The WBS divides the project into different deliverables and smaller, more manageable pieces representing an increasingly detailed definition of the project work. The project manager should ensure that the project team's efforts are focused on the work required to complete the deliverables of the project, not on other activities.

• Project schedule: The project schedule involves determining the period for each deliverable identified in the WBS and sequencing the deliverables in a logical order. Some deliverables in the project will likely be performed sequentially, and some executed in parallel to each other. It may be unclear for the project manager how much detail should be included in the schedule for a fixed-price project. The larger the project, complexity, and risk, the more level of detail is needed in the schedule.

• Manage to scope: The project manager should manage to the scope by carefully and tightly managing the fixed-price project. This is to ensure that no unnecessary extra cost or “gold plating” occurs and that the activities performed are within the scope of work per the contract requirements and are in line with the WBS or covered and approved by the client in a contract modification.

• Educate: Educate the project team and client. Education is key to having success in a fixed-price project. Not just the project team but the clients should be educated too. The clients need to know the project managers and their roles and obligations under the contract. So, the client knows how long they have to review and approve deliverables in the project.

• Internal project reviews: The project manager should hold regular internal project reviews. Regular internal reviews are excellent to measure progress toward completing and managing the project scope. This can show the ongoing process of the products or services to the contract requirements.

• Obtain acceptance: It is critical for the project manager to obtain the client’s acceptance of the deliverables under the contract terms in the project. This is both in writing and ongoing throughout the project’s period and performance. The project manager should clearly define the criteria if the client has not done so on specific deliverables. When the project manager agrees to perform a deliverable on a fixed-price project, the project manager should know precisely what they are expected to deliver by the client.

How to define the scope of work

As mentioned in the guide, the project manager should define the scope of work in a "joint venture" way with the client to develop the project scope, deliverables, product, or service, and will reflect the corresponding pricing assumptions proposed and accepted by the client. The project manager should always have a copy of the contract and other related documents and use these materials to remind themselves and their team what is in the agreed-upon baseline for the scope of work.

If fixed-price projects fail, one of the main reasons is not to have a detailed, well-defined, clear, and agreed-upon definition of the project's scope of work. One of the other reasons is changes to the scope of work were not appropriately managed.

Defining the scope happens in the proposal process. The project manager should ask many probing questions, “why do you want a stone wall?”, “what wood material should the floor be?” the “why” and the “what” questions propel the search for the scope until the project manager and the client agrees to it. Management expert Peter Drucker has noted: “Doing the right thing is more important than doing the thing right.” The right thing in a project is performing the agreed-upon scope of work. Use the “why” and “what” questions upfront in the project to minimize unclear deliverables.

How to manage the relationship with the client

In project management, communication is critical, especially in fixed-price projects. In fixed-price projects, the project manager should keep clients well informed of what they are doing to minimize waste of man-hours and materials on something the client believes to be wrong or not in line with the baseline of the scope of work. To prevent potential problems, the project manager should hold client meetings, outlines, and interim drafts. These client meetings should occur once every week or every second week.

Limitations

As mentioned, fixed-price contracts have the highest risk for the supplier and the lowest risk for the client. Therefore, the supplier needs to be very accurate when defining their offer for the scope of work. If the project’s scope of work is hard to define or unclear, a fixed-price contract will have too high of a risk for the supplier and project manager.

Some of the projects that may have a hard to define or an unclear scope of work, where a fixed-price contract is not recommended to be used are listed here:

- Administrative project

- Computer Software Development project

- Equipment or System Installation project

- New Product Development project

- Research project

In a research and development project, a fixed-price contract wouldn't work, while such projects have unlimited/broad scope and many variables that can impact the schedule, labor, materials, and overall costs.

The fixed-price contract is not perfect, here are listed five shortcomings and disadvantages to have in mind.

1. Comes at a higher price. A fixed-price contract gives the client a well-defined product or service for a fixed price. However, the risk in these projects is more significant for the supplier than in other projects. The supplier will account for the high risk in the price for the scope of work and will charge more than the supplier would for a time and material contract.

2. Planning takes a long time. In construction projects, the construction companies are good and experienced in planning projects. In some cases, the planning might take a long time. However, in software projects, the software companies define all the features in great detail, which can take weeks or months, before planning.

3. Rigid process. After the client and the supplier has signed the fixed-price contract, the supplier can change or add features. If the market demand shifts or new features are required, the supplier won’t be able to change the project’s scope of work. Sometimes the supplier can negotiate with the client for new features and then restart the planning process.

4. Not recommended for large-scale projects. A fixed-price contract works effectively for smaller projects, and construction projects. However, in large-scale projects with sophisticated scopes of work, like an e-commerce website or a multi-platform mobile app, the fixed-price contract will be too rigid or stiff.

5. There is a chance of miscommunication. As mentioned, in project management, communication is critical, especially in fixed-price projects. However, suppose the communication with the client is nonexistent or insufficient. In that case, the project manager will end up with an unclear and undefined scope of work, and the project, cost, and time will suffer.

key references

1. Lowden, G. & Thornton, J. (2015). The special challenges of project management under fixed-price contracts. Paper presented at PMI® Global Congress 2015—EMEA, London, England. Newtown Square, PA: Project Management Institute.

In this conference paper Lowden, G. & Thornton, J. provides knowledge on the special challenges of project management under fixed-price contracts. The paper is about the Risk Management, Cost Management, and how Manage a Fixed-Price Project.

2. A guide to the Project Management Body of Knowledge (PMBOK guide), 7th Edition (2021), and Managing Successful Projects with PRINCE2 2017 Edition

The guide to the Project Management Body of Knowledge (PMBOK® Guide) is PMI’s flagship publication and is a fundamental resource for effective project management in any industry. Over the years, business has changed considerably, but projects remain critical drivers of business success.

The book includes The Standard for Project Management. The standard is the foundation upon which the vast body of knowledge builds, and the guide serves to capture and summarize that knowledge.

The PRINCE2 is firmly established as the world's most practiced method for project management and is globally recognized for delivering successful projects. The updated 2017 guidance, its first since 2009, places a strong emphasis on the scalability and flexibility of the method and on how best to tailor it to the complexity and specific requirements of a project.

3. Fixed-Price Contract: What You Need to Know for Your Project

In this article William Malsam describes what you need to know for your fixed-price Project. The article describes also what should be included in a fixed-price contract.