In the world of projects, contracts are used for make or buy deals but also for establishing partnerships like Joint Ventures or for safety by buying insurances. The parties involved in this “engagement”, decide the type of the contract which varies depending on the type of the work and the nature of the industry.
A contract, to put it in simple words, is an elaborated agreement between two or more parties where one or more parties may provide products or services in return to something provided by other parties (client).
The contract type is the key relationship between the parties engaged in the business and the contract type determines the project risk as it shown below:
Let’s have a look at most widely used contract types:
Fixed Price (or Lump Sum)
Of all contracts, this is the simplest type, where all the terms are quite straightforward and easy to understand. The service provider agrees to provide a well defined service for a specific period of time and the client agrees to pay a fixed amount of money for the service. Inside this contract the parties may define various milestones for the deliveries, KPIs (Key Performance Indicators) and also acceptance criteria for the milestones and the final delivery.
The main advantages of this type of contract is that the contractor knows the total project cost before the project commences so the risk for him is low while for the seller the risk is high. Requires well-defined SOW and requirements.
In this contract model, the services provider is reimbursed for their machinery, labour and other costs, in addition to contractor paying an agreed fee to the service provider. In this method, the service provider should offer a detailed schedule and the resource allocation for the project. Apart from that, all the costs should be properly listed and should be reported to the contractor periodically. The payments may be paid by the contractor at a certain frequency (such as monthly, quarterly etc) or by the end of milestones. From risk perspective is the opposite from Fixed price contracts, while the risk lies on the shoulders of the contractor .
Time and Material (T&M)
This engagement type is the most risk-free or neutral type where the time and material used for the project are priced. The contractor only requires knowing the time and material for the project in order to make the payments. This type of contract has short delivery cycles, and for each cycle, separate estimates are sent of the contractor. Once the contractor signs off the estimate and Statement of Work (SOW), the service provider can start work.
A PMI-RMP candidate may face during the exam, a couple of questions regarding Procurements. Procurement documents are inputs at the Identify Risk process but they are also used at the Plan Risk Responses face for sharing or transfer risk strategies. So, selecting the contract type is one of the most crucial steps of establishing a business agreements. This step determines the possible engagement risks.
Therefore, companies should get into contracts where there is a minimum risk for their business. It is always a good idea to engage in fixed bids (fixed priced) whenever the project is short-termed and predictable. If the project nature is exploratory, it is always best to adopt T&M or Cost Reimbursable contract types.
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