Tips for Prospective PMPs - Edition 25

Welcome to the 25th edition of Tips for Prospective PMPs. This newsletter provides tips, advice, and lessons for those project managers pursuing the PMP?.

This edition includes an article on an introduction to procurement contracts for projects and access to 5 practice questions and mini-lessons.

Contracts for Projects

Project managers should be aware of the relevant components of a contract to a project and the various types of contracts that may be used in the procurement of services, products, or solutions.

Term and Completion Contracts

When work is to be provided by the seller, contracts can either be term or completion contracts. Term contracts end when the term has been completed. For example, the buying organization may enter into a contract with the seller to provide consulting services for a six-month term. The contract, in this example, terminates when the six months have expired.

On the other hand, a completion contract ends when the contracted work has been completed. For example, the buying organization may contract the seller to remodel a suite of offices. The contract will not be completed until the suite of offices has been remodeled per the contract terms.

Statement of Work (SOW)

Another consideration for contracts is the statement of work (SOW). The approach to the? SOW may vary depending on the level of detail and planning required. In general, two different approaches to the SOW may be taken:

• Design SOW.? The design statement of work is used when the buyer provides the seller with the exact details of what is required to be performed or delivered. This type of SOW is used when the buyer knows exactly what is required and prefers no deviation from the requirements. An example of a design SOW is where a buyer contracts a vendor to build custom cabinets for a commercial kitchen in a restaurant. The buyer provides the exact specifications of the cabinets in the SOW and requests a fixed-price bid for the work.
• Functionality SOW. A functionality SOW is used when the buyer provides a description of the work or outcome desired but allows the seller to propose a solution. An example of a functionality SOW is where a buyer desires to remodel a commercial kitchen but requests the seller to propose a remodeling idea, design, and solution.

Three General Types of Contracts

Let’s take a look at three general types of contacts used on projects:

Fixed-price contracts. A fixed-price contract is typically used for a well-defined product or work. The buyer and seller negotiate and agree to a price upfront. The price of the contract is what the buyer will pay and this price will not change unless a change order approved by the buyer modifies the work. The seller’s profit will be included in the price of the contract.

Generally, the seller has more risk in a fixed-price contract. If the work takes longer or becomes more costly than planned, the seller’s profit will be at risk. To mitigate the risk of losing profit or suffering a loss on the project, the seller should ensure that the work is clearly defined in the statement of work. The contract should define any assumptions to protect the seller’s risk.

There are three types of fixed-price contracts:

• Firm fixed price (also called “lump sum”).? The price is agreed upfront and does not change. This is usually supported by a well-defined SOW. A buyer should consider using this type of contract when the type of work is known and can be defined clearly. Although other considerations are taken into account in the award process, this type of contract allows the buyer to shop for the best-priced solution.
• Fixed price with an incentive fee (FPIF). This type of contract includes an incentive fee which is negotiated upfront to motivate the seller to meet a certain performance objective. An example of a performance objective is to complete the project thirty days earlier than planned. Another example would be to keep the costs of the project within or below a certain limit. FPIF contracts may also include penalties for not meeting certain performance criteria.
• Fixed price with an economic price adjustment (FPEPA). This type of contract is used for long-term contracts when the price of the contract may be adjusted on an annual basis to compensate for economic changes.

Cost-reimbursable (or cost-plus) contracts. This type of contract may be best suited where the parameters of the work to be performed are not well defined. This type of contract reimburses the seller for the actual costs incurred on the project plus a negotiated fee or profit. The risk on cost-reimbursable contracts is typically shared between the buyer and the seller. There are three variations of this type of contract:

• Cost plus fixed fee (CPFF). This type of contract reimburses the seller for actual costs plus a fixed fee which is negotiated upfront.
• Cost plus incentive fee (CPIF). This type of contract reimburses the seller for actual costs and adds an incentive fee which is used to motivate the seller to meet a schedule or other project objective or outcome.
• Cost plus award fee (CPAF).? This type of contract reimburses the seller for actual costs and adds an award fee which is determined in large part by the buyer’s assessment of the seller’s performance. This type of contract incents the seller to provide higher quality and service in return for a greater fee. Consider the relationship between a restaurant customer and the waiter serving that customer. The customer determines the fee (tip) to be provided to the waiter based on the customer’s assessment of the service.

Time and materials (T&M) contracts. This type of contract may be best suited when the statement of work cannot be defined clearly. This contract may also be useful for contracting a specific type of labor or expertise over a defined timeframe. This type of contract is considered a hybrid type of contract as it typically includes aspects of both fixed-price and cost-reimbursable contracts. Typically, the rate is a fixed price while the term may be open-ended.

The buyer incurs more risk than the seller because the contract tends to be more open-ended and is not tied to a specific outcome. The buyer can mitigate this risk by providing not-to-exceed limits or term limits. For example, a buyer contracts for a specialty engineer at the rate of $200 per hour with a not-to-exceed ceiling of $40,000 or 30 days. The contract terminates when the costs reach $40,000 or 30 days have elapsed, whichever occurs first.

Contracts for Agile Contracts

When contracting for agile projects, the following should be considered:

• Scope on agile projects is not typically well-defined upfront. This requires more creativity in the types of contracts used.? One approach is to use a time-and-materials contract with capped costs or not-to-exceed limits.
• Costs and schedules can be negotiated upfront allowing the scope to vary within those parameters.
• Incremental delivery of a product can be negotiated upfront. At each delivery milestone, the customer can make changes to the contract, continue the contract, or terminate the contract. This provides the buyer with more options and opportunities to assess the seller’s performance. This also encourages the seller to provide a higher level of performance and quality to continue the contract for additional profit.
• As most agile projects depend heavily on customer involvement, contracts for agile projects should specify the level of customer engagement required on the project.

Summary

When your project can benefit from outside services or contracted support, consider the various types of contracts and the best fit for the work to be performed. Awareness is the first step towards building a buyer/seller relationship.

If you are studying for the PMP? exam, understand the terms introduced in this article and the different types of contracts.

Eddie Merla, PMP

Article 2: Five Practice Questions and Mini-Lessons

Question #116: WBS

Question #117: Schedule planning

Question #118: Define activities

Question #119: Schedule dependencies

Question #120: Estimate activity durations

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