PMI RMP – PROJECT PROCUREMENT MANAGEMENT part 2

6. HIGHLIGHT: CONTRACT TYPES

Hi and welcome back again. So in this lecture we are going to talk about the contract types. If an organization decides to buy or outsource or procure from one or more companies outside the project, it must select the proper type of contract it needs. This topic is very important for sure for the exam and for your practical life as a project manager, you need to be aware of all the contract types. This is why it’s explained in a dedicated lecture. In selecting what type of contract to use, the primary objective is to have risk distributed between the buyer and the seller, both parties of the project or the contract, so that both parties have motivation and incentives for meeting the contract goal.

In selecting which type of contract to use, there are some factors that might influence your decisions. First of all, the extent of price competition, the cost and the price analysis. The urgency of the requirement or performance period do you need the goods or services you are procuring immediately or you can wait for a few months. The frequency of expected changes on the scope of the contract, the industry standards of type of contracts used, whether or not there is a well defined procurement statement of work or not, the overall degree of cost and schedule risk. These are the factors that might influence your decision.

Selecting the Contract Type there are three proved categories for contracts. The first one is the fixed price category. It’s also called the lump sum. Contracts involve a predetermined fixed price for the product and are used when the product is well defined. When the different fork is clear and the scope of the contract is well defined, the best to use the fixed price contract. Now, within this category there are three types of contracts. The second category will be the cost reimbursable. It’s also known as the cost plus contract and in this type the seller is reimbursed for completed work through invoices plus a fee representing the seller profit.

The third type it’s a hybrid contract in between the fixed price and the cost reimbursement contracts. Here the rest is distributed to both parties. A time and materials type of contract is generally used when the deliverable of the contract is labor hours. Now, let’s go through these categories. First of all we have the firm fixed price. The first type from the fixed price category contracts. So this is the simplest type of the procurement contract. It means that the buyer will going to pay one amount fixed amount, regardless of how much it costs the contractor to do the work. It only makes sense in cases where the scope is very well known.

It’s very clear in each detail if there are any changes to the amount of work to be done. The seller does not get paid any more to do it unless there is a change in the scope of fork of the contract. It’s a firm fixed surprise when to use. It’s mostly used in governmental or semi governmental projects and contracts where the scope of work is specified with every single and possible detail. Outline the drawback of using a firm fixed price contract that there is a possibility of disputes between the buyer and the seller if the scope is not clear. Moreover, any deviation from the original scope can cost you a lot as a buyer. An example of the firm fixed price contract the seller has to complete the job for $80,000 within twelve months.

Whatever the product is causing the seller, the buyer is going to pay $80,000 for the seller. This is a fairly fixed price contract. The second type is the fixed price plus incentive fee. Fbis it’s a complex type contract in which the seller bees higher risk financial incentives tied for the achieving agreed matrix. Typically such financial incentives are related to the cost schedule or technical performance of the seller. Performance targets are established at the outset of the project and final contract price is decided after completion of the project based on the seller’s performance. During the contract there will be an incentive for every dollar saved by the seller which reduces the cost below the original estimated target.

The cost savings are split between the seller and the buyer based on a share ratio. In case the cost exceeds, there’s a price ceiling and all costs above the ceiling are the responsibility of the seller. Therefore, if costs exceed the ceiling, the seller receives no profit. An example of the fixed price incentive fee will be adding a close into the contract such as $8,000 will be paid to the contractor as an incentive. If the contractor completes the work two weeks before the agreed upon completion date, this is the incentive. The seller will try to finish the project two weeks before the agreed upon accomplishment date to get these $8,000.

The third type of the fixed price would be the fixed price economical price adjusted. It’s a fixed up price contract that allows for price increases if the contract is expanded on multiple years. It is a fixed price contract but with a special provision allowing for predefined final adjustments to the project contract price due to change conditions like the inflation cost increases or decreases due to specific commodities, it’s usually because of the economy. The fixed price economically price adjusted is intended to protect both parties of the contract, the buyer and the seller from any external conditions that falls beyond their control.

An example of this contract will be adding a close like about 2% of the cost of the product will be increased after a certain time duration, both based on the US dollar to euro conversion rate. This is an example of the fixed price economical price adjusted contract. Now we will start with a cost reimbursable category. First of all we have the cost plus fixed fee means the buyer will pay the seller back for the costs involved in doing the project work plus a fixed fee that the buyer will be on top of that. If this agreed amount of fixed fee is calculated as a percentage of the initial estimated project costs it is referred as cost plus percentage of costs type contract.

So it’s either a cost plus fixed fee or a cost plus percentage of costs. This fee does not change with the seller’s performance. An example of this contract will be adding a close that the seller will be paid the invoice cost of the project in addition to $20,000 fee or the seller will be paid the invoice cost of the project plus 15% of those costs. The first example is the cost plus fixed fee. The second example is the cost plus percentage of costs. The second type will be the cost plus incentive fee where it means that the buyer will reimburse the cost of the project and pay a predetermined fee if seller meets certain performance goals or any other specific performance targets as decided in the contract.

It’s usually represented in terms of time or cost. In a cost plus incentive fee contract, if the final costs are less or more than the original estimated cost then both the buyer and the seller will share the costs based on a pre negotiated sharing formula which calls the sharing ratio. An example of the sharing ratio will be 60 40. The first number is the sharing ratio of the buyer. The second number is the sharing ratio of the seller. In a case of cost overrun or cost savings in a cost plus incentive fee contract the incentive is a motivating factor for the seller. If the seller is able to complete the work with less cost or before time, he may get some incentive.

The last type of the cost reimbursement would be the cost plus award fee. It’s very similar to the cost plus fixed fee contract except that instead of paying a fee on top of costs, buyer agrees to pay a fee based on the buyer’s evaluation of the seller’s performance. So what’s the difference between the cost plus award fee and the cost plus incentive fee? An incentive fee is calculated based on a formula defined, mentioned and stated in the contract and it’s an objective evaluation, numerical evaluation. An hour fee is dependent on the satisfaction of the client, the buyer and it’s evaluated in a subjective way. The award fee is not subjected to an appeal.

The last type will be the time and material contracts. It’s a hybrid contract. It’s also called unit price contracts. It’s the hybrid contract of the fixed price and the cost reimbursable contracts. A time and material type contract is generally used when the deliverable is labor hours. In this type of contract, the project manager of the organization will provide the required qualification or experience to the contractor who is responsible for providing the stuff. Best to use determined material when hiring some experts or any outside support. The buyer can specify the hourly rate for the labor with enough to exceed limit in order to protect the buyer.

A simple example is that a skilled labor will be paid $15 per hour. This chart is very important for the exam. The relation between the contracts and the risk, the risk on the buyer or on the seller. These are all the contract types. Cost plus percentage of cost. The cost plus fixed fee. Cost plus award fee. Cost plus incentive fee. Diamond material, fixed price economical price adjusted fixed price. Incentive fee. Firm fixed price. At the cost plus percentage of cost, the risk is on the peak for the buyer and in the fair fixed price, the risk is on the peak for the seller. So the highest risk on the buyer will be on the cost plus percentage of cost and the lowest risk will be in a fair fixed price and the opposite for the seller.

Remember and understand this chart for the exam. The last topic before we end this lecture the non competitive contract. There are two types of the non competitive contracts. The first one is the single source contract, where you contract directly with your preferred seller without going to the full procurement process. You may have worked with this company before and for various reasons you don’t want to look for other sellers. The second non competitive form of contract would be the sole source contract. In this type, there is only one seller who can provide you with the goods.

This might be a company that owns a patent. The last term is the nondisclosure agreement or the NDA, also known as the confidentiality agreement. It’s the legal contract between at least two parties that outline confidential, material, knowledge or information that the party wish to share with one another for certain purposes, but wish to restrict access to all by third parties. Usually, if you are managing an important project, confidential or government, before you share the bidding documents, you will ask the other party to sign on an undisclosure agreement. This is all for the contract types. Thank you so much. I will see you at the next lecture.

7. HIGHLIGHT: POINT OF TOTAL ASSUMPTION

Hi. We will come back again. So we have a small important topic before we go to the second process of the procurement management knowledge. So what’s the point of total assumption when it comes to the procurement management? Before I tell you the definition of the PTA, there are a few terms you need to be aware of. First of all, what’s the price? The price is the total amount the seller will charge the buyer. As a buyer, whatever you are giving the seller, this is considered as the price or the total or the final price of a contract. The profit or the fee. It’s the profit margin in mind of the seller. It’s planned into the price of the seller provides the buyer. If that contract is a fixed price contract, the buyer cannot know the profit or the fee of the seller.

It’s a cost reimbursable contract. Then the profit or the fee of the seller will be clear for the buyer. The cost is how much an item will cost the buyer. So the buyer cost the seller’s cost plus the seller’s profit. This is the cost of the contract, the target price. It’s a term used to compare the result with what was expected. It’s a matrix. It’s a measure of success. If we targeted the price to be $200,000 at the end of the project it was 2000 $105,000. This will be a measure of success. This is the target price, what we are targeting. The sharing ratio, usually incentives is expressed as a ratio. Either it was a saving or it was a cost overrun. For example, a sharing ratio 70 30 means that 70% of the savings or the overrun will be for the buyer and 30% will be for the seller.

The point of total assumption, or the PTA is the amount above which the seller pays all the loss of a cost overrun. Buyers assume that costs go above the PTA due to seller mismanagement. This is the PTA. This is what we are going to calculate in this lecture. At the PTA, or the point of total assumption, the buyer assumes that the cost go above this amount is due to the seller mismanagement. This is why the buyer will not reimburse the seller with any cost overrun above the point of total assumption. The point of total assumption only relates to the fixed price incentive fee contract type the formula we need to memorize for the PTA its decision price minus the target price divided by the buyer’s sharing ratio plus the target cost.

This is how we are going to calculate or find out the point of total assumption. In the exam you should expect questions which will ask you to calculate the final fee and the final price which will be paid by a buyer to the seller. Not only the point of total assumption questions, there will be some math questions asking you to find out the final fee and the final price. Of a specific contract. The mentioned above formula it’s only used with a fixed price and central fee contracts for remaining contract types, normal calculations is used to calculate the price and the fee. I’m going to show you an example. The note here that if the question does not mention if you are from the seller or the buyer side, consider yourself from the buyer side for the exam question.

The first example calculate the final fee and the final price for the cost plus incentive fee contract with this information. So as it is a cost plus incentive fee contract, the point of total assumption is not applicable here. It’s only applicable on the fixed price incentive fee contract. The target cost is $180,000. The target fee is $20,000. The target price is $200,000. The sharing ratio is 70 30. The actual cost is $160,000. So the target cost was $180,000. But the actual cost at the end of the project was $160,000. So there was a $20,000 of saving. Know that the actual cost is less than the target cost. The seller will share the savings with the buyer and the seller sharing percentage is 30%.

As per the sharing ratio, the total savings is $20,000. The seller share will be 20,000 by 30%, it’s $6,000.So the final fee for the seller would be the target fee, which is $20,000 plus the seller share of the cost savings we just calculated 20 plus six will give you $26,000. This is the final fee of the seller. Why? The final price of the contract where the buyer is paying the seller is the actual cost, which is $160,000 plus the final fee which is $26,000 $186,000. Without applying any formulas, simple calculations using the logic you can find out the final fee and the final price for any contract. Another example here.

Assuming you are the seller in this procurement, calculate the final fee, final price and the point of total assumption price for the fixed price incentive fee contract with this information. So the question is asking for the final fee, final price and the PT a given that the target cost is $600,000, the target fee is $55,000. The target price is $655,000. The sharing ratio is 80% for the buyer, 20% for the seller. The actual cost is $520,000 and the saving price is $900,000. First of all, you want to find out if there is a cost overrun or a cost saving. The target cost is $600,000. The actual is 520. So there is $80,000 cost saving. The seller share as per the sharing ratio given in the question is 20% $80,000 by 20% $16,000.

So the final fee is the target fee plus the seller share of cost saving at $71,000. So the final price of the contract will be the actual cost. Given the question as $520,000 plus the final fee we just calculated the buyer will pay the seller $591,000. And by applying the point of total assumption formula selling prices given target prices, will the buyer sharing ratio is 80% and the target cost is given? The point of total assumption is $906,000. This is all for this lecture. I’m going to revisit this topic at the end of this course by the math section. Thank you so much. So much. I will hear the next lecture to talk about the conduct procurement process.