PMI RMP – MATH FORMULA GUIDE part 5

8. CONTRACTS MANAGEMENT

Hi and welcome to the last lecture of this section. We are going to discuss the contract management, the math formulas related to managing the project contracts. Now, all the contracting falls into the procurement management processes which follow a really sensible order regardless the type of the project you are managing. First of all, you need to plan what you need to contract or what you need to outsource from external resources for your project. Then you plan how you will do it. Next, you send out your contract requirements to sellers. They bid for the chance to work with you. You pick the best one and then you sign a contract with them. These are the steps you need to follow whenever you are doing a procurement process on your project.

The first math concept I’m going to explain this lecture is the make or buy analysis used to determine which work or the problems should be accomplished in house. In house means making it and which should be purchased from external sources which is buying it. So for buying we will use external resources or the word outsourcing. For make we will use the in house term. Now, factors such as resource availability and skill sets, cost propriety information or confidential information, risks and other relevant factors are taken into consideration when conducting a make or buy analysis. At the end of this lecture you will be able to determine the final fee and final price of any types of contract. Also, you will be introduced to the concept of PTA or the point of total assumption.

So in this lecture I’m going to explain how to perform the make or buy analysis, how to find out the final fee and final price of any contract and what’s the PPA and how to calculate it. Now, the make or buy analysis techniques are used in the planned procurement management process. During planning, you must decide whether the project team will do all of the project work or if some or all of the work will be outsourced. This is the make or buy analysis for those situations that fall in between. Here are some factors to consider in your analysis. Use the information below as a guideline. You will need to tailor the information to fit within your environment.

So what are the factors you need to consider? Here are some reasons to make and here are some reasons to buy now, to make or to do it in house it might be less costly, maybe because you want to make use of the existing capacity, maintain direct control, maintain design secrecy, develop a new competency or company’s core competency and the availability of vesta. All are reasons to make or to do the work in House reasons to buy less costly used supplier skills small volume requirement limited in house capacity to maintain supplier relationships to transfer the risk this is one of the most important reasons. The Risk Transparency response Strategy to transfer the risk to a third party. This is why you need to buy sometimes or readily available in the market and a lot of other reasons.

But here are the major ones. Now, how to use the make buy analysis for the math concepts. Example number one. You are considering whether to buy or lease an item for your construction project. The daily lease cost is $200. In order to purchase this item, the cost will be $2,000 with daily maintenance cost of $40. How many days it will take for the lease cost to be equal to purchasing costs. Now, all the make or buy or buy or lease questions will be sold in the same steps I’m going to use. Now, first of all, you need to assume that x refers to these. Then you need to define the purchasing cost and the leasing cost. Purchasing cost as given in the question will be $2,000 plus $4 by x, where x is the number of days. This is the total cost of the purchasing decision.

The leasing cost will be $200 per day multiplied by x, where x refers to the number of days. Now, the equation of calculating the days for both being equal will be 2000 plus 40 x, which is the purchase cost equals 200 by x, which is the lease cost. Now, bring the story here. You will have 2000 equals 200 -40. X. So 2000 equals 160 x. X is 12. 5 days. What does that mean? This is the break even number. If you are using this item for less than 12. 5 days, it’s better to lease it. If you are using it for more than 12. 5 days, it will be better to purchase this item. Example number two. You are considering whether to buy or lease a machine for your plant. Your finance department has provided you with the following information buying cost is $29,000.

Procurement management cost is $1,000. So this is the buying cost or the purchasing cost. If you are going to lease this machine, the leasing cost involves $10,000 as down payment and $5,000 per month as license C. What’s the break even duration after which buying the machine is preferable? So we will follow the same steps of the previous example. First of all, assume X refers to Montess. The raising cost will be $10,000 as given here. It will be down payment of 10,000 plus $5,000 per month by the number of monkeys. Why? The buying decision cost will be $29,000 plus 1000. For the procurement management, it will give you a result of $30,000. Then the equation of calculating the breakeven will be $30,000 equals 10,000 plus 5000 by x.

So 20,000 equals 5000 x. So x equals four months. The break even is reached after four months. So if you are using this machine for less than four months, leasing is better. For more than four months, buying is better. Now, the second topic is the point of total assumption or the Bta. This concept is only related to fixed price incentive fee contracts. FBI it refers to the amount above which the seller gives all the losses for an additional cost overrun. So it’s the amount of money above which the seller bees all the losses of an additional cost overrun. This is exactly the point of total assumption. Now why the cost was going to pay or to be all the losses because buyer assumed that the sellers reached this amount due to poor management.

Now, the concept was when the buyer and seller have agreed on criteria for fixing the price and that the buyer is willing to repay part of cost overrun until it reaches the ceiling price. I discipline this more in the coming example. Now here are some terms you need to be aware of before we go through some math. What’s the target cost? This is the estimated budget which the seller has planned for delivering the given project. It’s like project budget. This target cost is shared with the buyer and the process of estimating the project budget is also very transparent. So the target cost is the amount, it’s the estimated budget which the seller has planned for delivering the given project and this number should be stated in the contract. It should be clear for the buyer and the seller and the process of estimating the target cost should be very transparent.

Now the target fee, it’s the fee which the seller wants to charge for the work he is doing. It’s the target fee, the target profit the seller will make from this contract. Target cost is the cost of the work. Target fee is the fee of the seller, it’s the planned fee. The actual fee of the contract will depend upon how well the seller manages the project if there is any cost savings or cost overrun. So the target cost and the target fee are stated from day number one in the contract. The target price, it’s the sum, it’s the price the buyer is looking towards and it’s the sum of total the target cost plus target fee. Both the seller and the buyer use it as a benchmark. If the final project costs less than this price buyer and seller will share the profit as per the profit sharing agreement.

If the price goes beyond the target price buyer and seller share the cost as per the cost sharing agreement subject to the maximum ceiling of the selling price and the ceiling price is given as well in the contract from day number one. So this is the target price, it’s the sum of the target cost and the target fee. What about the sharing agreement or the sharing ratio? There are two types of ratio one for sharing profit when the project costs less than the target cost and one cost sharing ratio when the project costs more than the target cost. But sometimes it’s the same for sharing the profit or sharing overruns. An example of the sharing ratio will be 80 20. Always the first number refers to the buyer. The second number refers to the seller.

Now, what’s the formula of the point of total assumption? PTA equals the ceiling price minus the target price divided by the buyer’s sharing ratio plus the target coast ceiling price target Price the buyer’s sharing ratio in this example here is 0. 8 plus the target coast. Now let’s show some examples find out the point of total assumption for the case with information shown in table below. So we have this contract. The target cost is $150,000. The target fee is $30,000. The target price equals $180,000. The sharing ratio is 80 20. The ceiling price is $200,000. Now the solution the PTA or the point of total assumption equals the ceiling price minus the target price divided by the buyer’s sharing ratio plus the target cost.

Ceiling price is given. Target price is given. The buyer’s sharing ratio as well is 0. 8 and the target cost is given. So by plugging in these numbers into the formula, you’ll have the PTA of $175,000. What does this amount mean for the project? It means that the cost of development should not touch the $175,000 or the point of total assumption and it should be the target of the seller. If it touches the PTA then all further cost overrun the seller has to pay. This is the point of total assumption now here is an example of how to calculate the final fee and final price of a contract. Example number two you are the seller in this procurement in this fixed price incentive fee contract, the target cost is $9 million and the target fee is $850,000.

The project is done and the buyer had agreed that the costs were in fact $8 million. Because the seller cost came in lower than estimated cost. The seller shares in the savings 80% for the buyer and 20% for the seller can create the final fee and final price given that the seating price is $12,500,000. So it’s given in the question that the target cost was $9 million. At the end of the contract, the actual costs were $8 million. So we have 1 million of savings. Note that the actual cost is less than the target cost the seller will share the savings with a buyer the cost savings is 9 million -8 million $1 million and the seller share is 20% 20% by 1 million is $200,000 and the target fee was 850.

You need to sum these numbers to find out the actual fee and the final fee which is the target fee plus the seller share. 850,000 plus 200,000 will give you $1,050,000. The final price equals the actual cost plus the final fee. The actual cost is 8 million. The final fee is 1,000,050. So the final price of this contract is $9,050,000. For any question asking about the final key and the final price, use these steps. The first step will be to determine if there is a cost saving or a cost overrun. You need to find out the seller share of this saving or overrun. After that, you will find the finalty and the final price. This is all for the contracts management math. Now, you have a long quiz of 50 valuable math questions. After that, we’ll be solving these questions together. Thank you so much. I will see you after request.