Fixed-price contracts

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. (7)

A fixed-price contract is a contract where the agreed-upon price for the job is unchanged throughout the project. It doesn’t matter if more time, materials or labor must be used than first estimated, the price stays the same.

Therefore, the scope of work the contractor defines in their bid must be very accurate. Once the quote is determined, it is shared with the customer. If the customer agrees with the price for the work, it is cemented as final and no change in man-hours or cost of materials can be considered. (1)

When a project proceeds under a standard fixed-price contract, the contractor can't renegotiate the price. If something like a material shortage, price hike, or labor shortage comes up, the contractor will have to shoulder the problem themselves. The contractor could communicate with the owner and possibly amend the contract, but the owner is under no obligation to do so.

However, if the owner changes the scope of work, the contractor may see a change in the contracted price. If the owner changes the plans, changes materials, or otherwise alters the amount of work required from the contractor, the price can go up or down. (2)

Fixed-price projects have a higher risk/reward profile. They pose more significant risks in exchange for more reward if the proposal is appropriately bid, the work is well managed, and changes are processed as contract modifications. The project manager needs a little finesse to remind the buyer or customer that a difference the customer is asking to perform is out of scope and requires a contract modification. The project manager should also have a project team that understands the nature of fixed-price work. (5)

Significantly, in a project being performed under a fixed-price contract, the client is buying a defined set of services for a set price. If completing the scope of work and producing the deliverables takes more effort or otherwise costs more than what was budgeted, the client will not pay more than the fixed price. (5)

Projects also may be performed for clients under two other general types of contracts.

• Time-and-material (T&M) contracts: These allow the client to acquire services or products based on hourly rates listed in the contract and materials, as applicable, sometimes with materials handling charge. Suppose the project takes more time, effort, or cost to complete than initially assumed in the contract. In that case, the supplier performing the task is not obligated to continue working once it has expended the budget or ceiling. The risk of additional time and costs generally falls on the client. This type of contract is appropriate when the scope is less well-defined or could change during the project. (5)

• Cost-based contracts: Also referred to as cost-reimbursement contracts, these provide payment of allowable incurred (actual) costs to the extent prescribed in the contract. These contracts establish a total cost estimate to obligate funds and install a ceiling. The client carries more risk in cost-based agreements, as the supplier delivers “best efforts” to meet the contract requirements. Cost-based contracts often are used where the precise specifications cannot be articulated. (5)

Basic Elements that are included in a Fixed-Price Contract

A Fixed-Price contract has similar components to a contract that outlines work and payment. In general, a fixed-price contract includes the following basic elements. (1)

Project Information:

• Owner: The person or organization who is hiring the general contractor for the project.

• General Contractor: The person bidding for the work. They are the overriding contractor, managing the project and any subcontractors and third-party vendors.

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

• Scope of Work: Detailing of what the contractor will provide, project plans, schedule, specifications, etc.

• Price and Payment: The total price for the job, which is fixed and unchangeable throughout the project, how and when payments will be made by the customer to the contractor.

Supporting Documents and Costs:

• Documentation: Attach 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, including the starting and completion dates, milestones, and other important dates.

• Licensing and Permits: Who will be 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 contractor warrants the work and material defects.

Closure:

• Termination: When can the contractor can end the contract.

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

• Insurance: Insurance obtained by customer and contractor protecting against damage, claims, etc.

• Liquidated Damages: Agreed-upon sum the contractor will pay for each day the project goes over the contracted deadline.

• Force Majeure: Neither party is responsible for events that occur due to circumstances beyond their control, such as weather, supply shortages, Corona, etc.

Fixed-Price Contracts buildup

From the client's and supplier's standpoint, a typical buildup of the price for a fixed-price contract and project. (5)

Supplier's standpoint:

The expected cost of undertaking a project is comprised of two parts:

(1) The base cost estimate.

(2) The cost associated with a contingency reserve, providing the allowance for additional activities that may be needed beyond what was assumed and planned in your base cost estimate.

Profit is also comprised of two parts:

(1) A management reserve, if used, to be tapped in an emergency if any unforeseen risks may occur.

(2) The appropriate profit for the type of project, 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.

Types of Fixed-Price Contracts

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

To accommodate different scenarios, there are several different types of fixed-price contracts. (2)

1. Firm Fixed-Price Contracts: Firm fixed-price contracts give the contractor little work change. These contracts are not adjustable, and the contractor must complete the project for the awarded price. The contractor accepts 100% of the profit or loss during the project.

2. Fixed-Price Incentive Contracts: Fixed-price incentive contracts use a formula to determine profit. A fixed-price incentive contract uses the final negotiated price and compares it to the target price to adjust the profit on the project. Every project has a target cost and a target profit, which add up to the target price. Projects also have an actual cost and an actual price. The actual price is the sum of the actual cost and actual profit.

3. Fixed-Price Contracts with Economic Price Adjustment: Fixed-price contracts with economic price adjustment afford the contractor with a bit of an insurance policy. The price can be adjusted up or down according to contract-specific contingencies outside of the contractor’s control. For example, if material costs go through the roof, the contract amount can increase to cover the increased costs.

4. 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.

5. 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

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.

Limitations

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.