Fixed-price contracts

Revision as of 10:31, 18 March 2022

Developed by Tobias Nielsen

Abstract

A Fixed-Price Contract (also referred to as a lump-sum contract) is a contract where contractors and clients agree to an unchanged set price for a project. (3)

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. All 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. (6)

The first aspect involved in any project is of course 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. There are different types of contracts that a project manager can use, some of them are listed here. (7)

- 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 with a fixed time period. This kind of contract is often used for architectural, engineering, or information engagements. (7)

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 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 is it important for the supplier to be very accurate when they define their bid for the scope of work. Once the bid 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. (1)

When a project runs under a fixed-price contract, the supplier can't renegotiate the price. If something is taking more man-hours or there are required more material than expected, the supplier will have to deal with this extra cost themselves. The supplier can communicate with the client for a change in cost, but the client is under no obligation to do so. If the client changes the scope of work, the supplier can expect a change in the contracted price. (2)

Projects with a fixed-price contract have a higher risk/reward profile. The risk in these project is more significant for the supplier than in other projects, but in exchange for more reward, if the project is accurate bid, 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 on figur 1, fixed-price contracts has the highest risk for the supplier, and the lowest risk for the client. It is also shown that the time and materials contract has to 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 is it important for the project manager to manage the six aspects involved in the project, and have discipline, when running a project under fixed-price contracts. (5)

Figur med RISK

Basic Elements that are included in a Fixed-Price Contract

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. (1)

Project Information: • Owner: The person or organization that is hiring the supplier for the project. • Supplier: The person bidding 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 payments will be made by the customer 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 protecting against damage, claims, etc. • Liquidated Damages: The agreed-upon sum that 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.

Fixed-Price Contracts buildup

As shown in figur 2, the client's and supplier's standpoint, of a typical buildup of the price for a fixed-price contract and project. (5)

Supplier's standpoint:

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

(1) The base cost estimate, which is the total planned/budgeted cost.

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

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

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

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

Client's standpoint:

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

Figur af Biuldup of fixed-price

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. (2)

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 price that are set. 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 final price of the project, 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 gives the supplier an insurance policy. The set price of the project can be adjusted up or down. For example, if corona/covid 19 is responsibly for material costs to go through the roof, the contract set price amount can increase to cover the increased costs of materials.

Fixed-Ceiling-Price Contracts with Price Redetermination: There are two types of price redetermination contracts; prospective and retrospective. They both have ceiling prices established at the beginning of the project, which is the most the client is willing to pay for the work. Contracts with prospective redetermination allow for price adjustment at a specified time or times throughout the project’s lifespan, the pricing periods are at least 12 months long. Contracts with retrospective redetermination allow for an adjustment to contract price after the completion of the project. This contract type applies more to research and development contracts than construction.

Firm Fixed-Price Level-of-Effort Contracts: Firm fixed-price level-of-effort contracts require the contractor to provide a specified level of effort (labor) for a specified period. The clients pays a stipulated price for this work.

Application MANGLER

The fixed-price contract is often used when dealing with a repeated process. For example, when the project will be done over and over again to a standard set in advance, a fixed-price contract is advisable. The costs are going to stay relatively the same throughout.

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. (1)

They’re easy to understand, as the cost of the project is clearly stated and will not change. The customer knows how much the project will cost, and the contractor knows how much they can spend. Since everything is understood, there are likely fewer disagreements.

A price-fixed contract is a profitable but risky proposition, as the bids must be very accurate to make sure the contract is able to make money from the work. The contractor can potentially bring the project in for even less than the agreed-upon price, adding to their bottom line. (1)

To succeed at fixed-price contracts and work, the project managers should employ as much project management rigor and discipline as possible, more than T&M or cost-based work. The kind of discipline that is needed to follow on fixed-price contracts includes: (5)

• Define the scope: Work jointly with the client to develop the project scope, objectives, and deliverables. Ensure that the area of work, the basis of estimate, or equivalent contract document defines clearly (preferably with specific, purpose, and attainable criteria, as well as any assumptions) what constitutes the completed and accepted deliverables.

• Develop a work breakdown structure (WBS): A WBS is a hierarchical decomposition of the work, helping the project manager to see both the individual components and the totality of the work. The WBS subdivides the project into its various deliverables, then into smaller, more manageable, and discrete pieces of work within each descending level of the WBS, representing an increasingly detailed definition of the project work. The project manager should ensure that the team's efforts are appropriately focused on the work required to complete the deliverables specified or otherwise needed to perform the project's scope, not on other activities.

• Project schedule: This step involves determining the durations for each activity identified in the WBS and sequencing the activities in a logical order. Some activities likely will be performed sequentially, and some executed in parallel. Project managers may be uncertain about how much detail should be included in the schedule for a fixed-price project. The level of detail is driven by the project’s size, complexity, and risk.

• Manage to scope: The project manager should carefully and tightly manage the fixed-price project to ensure that they do not incur unnecessary costs (no “gold plating”) and that the work performed either is within the scope of work per the contract requirements and, in turn, the scope baseline and WBS or covered by a change order approved by the client in a contract modification.

• Educate: Educate the project team and client—Education is needed, not just for the project team, but often for clients too. In particular, clients need to know both the project managers and their roles and obligations under the contract.

• Internal project reviews: Hold regular internal project reviews. Regular reviews are an excellent method to measure progress toward completing and controlling the project scope. Studies can facilitate your ongoing assessment that the products or services under development conform to the contract requirements and meet the contract's acceptance criteria.

• Obtain acceptance: Keep in mind the critical need to obtain client acceptance of the deliverables, under the terms of the contract, both in writing and, ideally, on an ongoing basis throughout the project’s performance. The project manager should clearly define the criteria if the client has not. When the project manager agrees to perform a task on a fixed-price basis, it is not unreasonable for the project manager to want to know precisely what they are expected to deliver.

What is the Process for Making a Change to the Scope of Work? Skal også med!!!

Limitations MANGLER

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.

key references

(3-10), where a reader can find additional information on the subject.

References

1. https://www.projectmanager.com/blog/fixed-price-contract

2. https://www.levelset.com/blog/fixed-price-contract/

3. https://www.coconstruct.com/blog/builders-use-fixed-price-construction-contracts-80-of-the-time

4. https://learn.financestrategists.com/finance-terms/fixed-price-contract/ Ny!!!

5. https://www.pmi.org/learning/library/challenges-fixed-price-contracts-9640 Ny!!!

6. Managing Successful Projects with PRINCE2 2017 Edition

7. A guide to the Project Management Body of Knowledge (PMBOK guide), 7th Edition (2021)