Getting ready for the PMP Exam: Contract Risk
Getting ready for the PMP Exam: Contract Risk
My students regularly identify four areas with significant question volume on the PMP® exam: schedule diagrams, earned value management, risk calculation, and procurement. This feedback may reflect the preponderance of mathematics in the first three topics. Project Procurement Management crosses four of the five process groups identified in A Guide to the Project Management Body of Knowledge 5th Edition®. This creates the opportunity for questions across the process groups rather than heavily within a single process group (usually the Planning Process Group). Historically, procurement management has been light on mathematics. Indeed, there are no equations or graphical representations in Chapter 12-Project Procurement Management of the PMBOK®.
In our PMPC preparation course, I regularly emphasize the integration with other knowledge areas and insight that procurement is equivalent to a sub-project. Procurement is effectively the establishment of a micro project with the make-buy decision preceding procurement equivalent to the cost-benefit analysis that precedes creation of our project charter. The project manager, purchasing agent, or contract administrator becomes the sponsor while the seller’s representative serves as the project manager. The output of the procurement is a product or service, a subset of our project’s overall deliverables. Comparisons and contrasts between projects and procurement enable PMI to evaluate the candidate’s ability to comprehend knowledge area integration.
An understanding of risk is most directly associated with the selection or development of contractual relationships within Procurement Management. The selection of contract type correlates closely to the continuum from risk avoidance, through risk mitigation toward risk acceptance.
If we clearly understand project needs and can specify them objectively (knowns), we can place the risk upon the seller. When the nature of the work is less well understood (unknown-unknown), we may be guided to negotiate a time and materials contract that places more of the risk on the buyer whom we represent. Cost-reimbursable contracts fall within the spectrum between fixed price and time-and-materials options, closely related to mitigation or transference (known-unknowns).
The PMBOK 5th edition® offers options within each contract type that provide a risk continuum which the exam candidate must understand. The list of contract options from least risk for the buyer (project) to most risk for the buyer are:
- Firm Fixed Price (FFP)
- Fixed Price Incentive Fee (FPIF, aka Fixed Price Incentive or FPI)
- Fixed Price with Economic Price Adjustment (FP-EPA)
- Cost Plus Award Fee (CPAF)
- Cost Plus Incentive Fee (CPIF)
- Cost Plus Fixed Fee (CPFF)
- Cost Plus Percentage Cost (CPPC)
- Time and Materials
It must be noted that the terms of a Time and Materials contract may place it higher in the risk order, though it is generally considered the highest risk for the buyer unless clear constraints are identified.
I will provide insight into each of the contract types, though you will first need a few terms that are not defined in the PMBOK®. You may see each, or even all of the terms, and associated values on any given exam contract question. Understanding their context will enable you to better answer related questions.
Target Cost: The cost that you (as the buyer) have determined matches the value you need for the work to be provided.
Target Fee/Target Profit: The compensation that you are willing to provide the seller in exchange for product or services. The target fee is typically determined as a portion of the target cost. The target fee might be initially set as a fixed amount or as a percentage of your estimate of the value of the work.
Target Price: The sum of the Target Cost and the Target Fee. Note the possibility of confusing the difference between Target Cost and Target Price based on the contract type. For instance, with a Firm Fixed Price Contract, the Target Cost and the Target Price may be the same.
Share Ratio: A ratio representing the percentage risk assumed by each party, noted a NN/NN where the first NN value represents that risk assumed by the buyer (you) and the second NN value represents the risk assumed by the seller. For example 10/90 would identify that you (buyer) assume only 10% of any risk experienced while the seller assumes 90% of the cost of the risk. The use of the share ratio may be the most confusing of the terms. A higher share ratio for the buyer DOES NOT MEAN that the contract type is a higher risk. Pay attention to the list above to determine which contract type affords the greatest risk avoidance or risk acceptance. The share ratio is used to determine seller compensation relative to contract type and in conjunction with the Target Fee or Target Profit range assigned to the contract. Once a contract type is selected, the share ratio helps to determine the terms relative to the Target Fee and does not change the nature of the contract. For instance, in an incentive based contract, the seller percentage may be as low as 5% or 10%, and this would affect a share ratio something like 95/5 or 90/10.
Ceiling Price: The maximum amount you are willing to pay. This term is more typically applied to Cost Plus contracts, where the actual costs may push the payment above the Target Cost or even above the Target Price if initial estimates are incorrect. Once the Share Ratio starts to apply to compensation calculations for a Cost Plus contract, the Ceiling Price represents the maximum price that you will pay. Ceiling price protects the buyer.
Maximum Fee and Minimum Fee: Though not used on all contract types, these values would represent the maximum and minimum compensation for the seller regardless of the seller’s ability to significantly over or under perform contract terms. Once the share ratio applies, maximum fees protect the buyer and minimum fees protect the seller. These fees typically apply to Cost Plus contracts.
Now, let us look at each contract type based upon the terms and their relationships. The PMP exam may ask you to calculate actual payments fees or total payments based upon these concepts, which may be the topic of a later blog. In the interim, Aileen Ellis has a great little book entitled “How to get every Contract Calculation question right on the PMP® Exam” that covers the calculations in detail and provides 50 sample questions. The book is available in print or e-book format from Amazon.com for a nominal cost.
Firm Fixed Price
The seller bears all the risk and performs the contracted work as identified in the Statement of Work.
The share ratio for this contract type is 0/100. The cost of the work is the Target price, regardless of any over or under runs by the seller.
Fixed Price Plus Incentive
The seller performs the work, bearing the risk of the project. The share ratio is used if the seller under-runs the cost of the work, as a means to determine how much more than the target fee the seller will earn for outperforming the goal. Note that the share ratio might appear in favor of the seller, for instance 80/20. This does NOT necessarily suggest that the buyer (you) are assuming more risk. The share ratio is used to determine how much of the over run the seller will be penalized or how much of the under-run margin the seller will receive in addition to their target fee or target profit. Using my 80/20 example: If there is an overrun, the seller would be penalized 20% of the overrun against the Target Fee, and the Ceiling Price would not be exceeded. If there is an under run, the seller would receive 20% of the under run added to their Target Fee as an incentive, effectively increasing their profit up to the Maximum Fee.
Fixed Price Plus Economic Adjustment
This form of contract typically occurs when elements of the service or product deliverables are subject to market volatility. This is more common for longer term contracts that would be subject to market based price changes. Although within the fixed price category, the Ceiling price is not fixed except for items within the contract that are determined NOT to be affected by market rates. For example, the production of good might be fixed, but the cost of transportation and delivery might be locked relative to market fuel and labor rates. The Statement of Work would clearly identify the specifications for the product, as well as which items might be considered to vary with the market. In other words, the Statement of Work would not be open ended as might occur with a Cost Plus or Time and Materials SOW.
Cost Plus Award Fee
For this and the other Cost Plus contracts, payment of Target Fees or Profit are added to the actual cost of the Product or Service, and a Ceiling Cost is unlikely to be stated. The Target Price therefore varies based on the actual cost of the work performed or product that is delivered. There is usually a Base Fee that equates to the Target Fee as a percentage of the overall Target Cost. The buyer (customer/project) UNILATERALLY determines an additional Award Fee amount that may be paid periodically or as a lump sum if the seller performs better than Target Cost or under runs the Cost. This form of contract requires an Award Fee Plan that determines how awards will be calculated and awarded whether periodically or over a specified time period.
Cost Plus Incentive Fee
Incentives are provided to the seller relative to the actual Cost rather than relative to the Target Cost. In this instance, the buyer bears more of the risk since there is no Ceiling Price. The actual price of the contract becomes a combination of the actual cost plus the compensation provided to the seller. The maximum price, should there be an overrun of the Target Price, would be a combination of the Actual Cost plus the Minimum Fee paid to the seller. The minimum cost would occur should the seller under run the cost sufficient to achieve their Maximum Fee, which would be added to the actual (lowest cost) to create the Actual Price paid. Between the Minimum Fee and the Maximum Fee, the seller receives the Target Fee plus or minus a percentage of the under run or overrun added to the Cost. For instance with a Share Ration of 80/20 and an under run against the target cost, the seller would receive their Target Fee plus 20% of the cost under run, until the Target Fee plus 20% of the under run matched the Maximum Fee. Note that in any case the Fee received by the Seller is added to the Actual Cost, rather than compared to the Target Cost or Ceiling Price as would occur with a Fixed Price contract.
Cost Plus Fixed Fee
Similar to both of the previous two Cost Plus contract types with one major difference: the compensation provided to the seller is not scalable once the contract is negotiated. The Target Fee is determined as a percentage of the Target cost, and then locked as a specific monetary amount. In the case where the seller under runs the target, they are given a fixed amount rather than merely a percentage of the difference. This guarantees the seller a specific income, reducing the seller risk. In the case of a cost overrun, the seller also receives their fee, rather than a reduced payment structure.
Cost Plus Percentage Cost
Although not mentioned in the PMBOK 5th Edition®, it is common for sellers to prefer a contract that assures a fixed percentage profit for work performed. The percentage represents a guaranteed profit margin, regardless of cost. The disadvantage to the buyer includes the consideration that sellers will not strive to reduce the costs, since the higher the Actual Cost, the higher the fee received.
Time and Materials
Within a time and materials contract, the seller may change the seller any verifiable costs for the project, including business overhead, profit and operating margins. The procurement Statement of Work is typically open ended, allowing the buyer and seller to negotiate changes as the nature of the work is identified. Without a specific closure for deliverables, the costs associated with a Time and Materials contract may run higher than desired by the buyer before a viable product is delivered.
As you prepare for the PMPC exam, or consider the negotiation of a procurement agreement, make sure that you understand the relative risks to the buyer and the seller for each of the options.
An experienced project manager will conduct a Force Field analysis, determining the factors associated with both buyer and seller risk, in the process of selecting the most appropriate contract type.
I hope to see you in the classroom, or online!
Steve teaches PMP: Project Management Fundamentals and Professional Certification, Windows 7, Windows 8.1 and CompTIA classes in Phoenix, Arizona.
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