PMI CAPM – Procure Goods and Services in a Project Part 2

3. Review Project Procurement Contracts

Welcome back. In this lecture, we’re going to look at reviewing the procurement contracts, what contract types and what are the characteristics of those contracts are you allowed to use in your project? And you’ll need to recognize these for your PMP exam. This is an area that tends to beat up a lot of project managers because most PMS aren’t working with contract types. They’re not doing the procurement that it’s managed by a centralized contracting or a procurement office. So if you don’t have a lot of experience with these different contract types, pay attention to these in this lecture. Maybe spend a little bit extra time.

So you know these for your exam. All contract types are a formal agreement. The United States will backup contracts through the court systems. Contracts state all of the requirements for product acceptance and that any changes to the contract have to be formally approved, controlled, and documented. Both parties have to be in agreement to that change. Contracts can be used as a risk mitigation tool. And we saw that in chapter eleven in the Pinbach where we talked about risk transference, that we hire someone to own the risk.

Now, the legalities of a contract, there are two big types of contracts. We have a fixed price or cost reimbursable. A fixed price is just what it sounds like that I will come build a deck for you on your business, a big, beautiful deck on the back of your business where people can sit outside and eat their lunch or whatever. And I’m going to do that for $25,000. That’s it. That’s all you’re going to pay. It’s a fixed price. So if I have wasted materials or the price of that wood goes up, that’s on me because I’ve already quoted you $25,000. Cost reimbursable are more dangerous for you. Cost reimbursable contracts mean that you’re going to pay me a fee for me to actually build it, but you have to buy the materials. So they’re called a cost plus or cost reimbursable.

So I’ll come build the deck for you, and you’re going to pay me $15,000 plus the cost of materials. So the danger, of course, if I waste materials or my crew, you know, waste materials, they cut stuff wrong, and we have to buy more materials. Well, you have to pay for those. It’s cost $15,000 plus whatever we spend on materials. So a little bit more dangerous for you, the buyer. Now, contract legalities. They have to contain an offer, and they have to be accepted by both parties. So what we often say is, there’s an offer I will offer to come build that deck for you in consideration of the $25,000 you will pay me. So an offer and a consideration, and both parties agree to it, and they sign the contract. So the terms of the contract are spelled out. An offer is the work.

The consideration is the payment. And then they have to be for a legal purpose, they have to be executed by someone with capacity and authority. And this is pretty obvious, right? If I can’t go to a big bank and say, hey, I want to do a whole bunch of training for you, happy to come teach some project management for you at your company. And the person I’m talking to is a janitor there. And they say, sure Joe. And they sign that and there you go, there’s your contract. Well, that might be a real nice person I was talking to, but they don’t have the capacity or the authority to be signing that on behalf of that business.

So they have to be signed by someone that has the capacity and the authority that they are the ones, the decision maker, and they can back up. They have the permission of the bank to sign that contract. Let’s talk about some of these contract types. The first ones are really pretty safe. We have these fixed price contracts. These are the most common. I’ll come build that deck for $25,000. We will create a website for $8,000. You’re going to buy 20 books for X amount of dollars. So a fixed price pretty safe. The seller carries the risk of cost overruns. So if we have wasted materials, if it takes us longer to build the website than we thought, if shipping costs too much, we have to carry the cost overruns as the seller. The buyer specifies exactly what’s to be purchased.

So we have to be in agreement as to what you’re buying here and what you’re paying for. Any changes to the scope, though, can introduce more negotiations and more time and money. So you want me to come build this deck, this outdoor seating on the back of your business and I’m out there building the deck and you come out and you say, you know what, Joe, I think it would be great if we could have some benches out here as well. So in these little areas, I want you to put some benches in. All right, I can do that. Happy to do it. Great idea.

But now we’re changing the scope. We’re changing the agreement that we have. So you’re going to have to pay for me to add those benches to the project. So that might be some new contract. It could be an addendum to the existing contract or our existing contract. Sometimes we’ll have a clause where we can do changes up to X amount of dollars if we’re both in agreement on the change, but a firm fixed price. So if you do changes, that doesn’t mean that I don’t have to increase my cost. If you change what you want, we already have an agreement to build this deck. Then we have a fixed price incentive fee. What this means is I’m going to give you some type of a bonus or an incentive for performance. So Joe, I’ll pay you $25,000 to build that deck.

But I’ll give you $1,000 bonus if you can get done a day early. So there’s a bonus to get done. Cost schedule and technical performances could be tied to this incentive. So if you can bring the life cycle costing down, if you can beat a deadline, if you can ensure that it has 99% uptime, then we’ll give you a bonus. Sometimes that bonus will have a price ceiling. There was a major construction project, I remember, in Indiana where the the company doing the construction project, it was a highway construction project that if they got done early, for every day they were done early, they could receive $1 million. So this construction company, they worked around the clock twenty four seven to fix this problem they were having there in the interstate.

And I believe the max they could earn was like $20 million. So if they came in at 25 days early, they didn’t get 25 million. There was a ceiling as to this incentive. So a price ceiling means you get a bonus up to this amount. The seller carries the risk of cost overruns. So if you think about that construction company in a million dollar bonus, they may have spent, let’s say, $750,000 a day in order to get a million dollar bonus per day. So they netted $250,000 per day in that bonus. Well, if they had a piece of equipment breakdown or another delay in the project, they may not get their bonus or as much of a bonus. In fact, they could be upside down on the project because of all the extra labor that they’ve added. So the seller will carry the risk of any cost overruns in a fixed price incentive fee. Like, you’re going to give me a bonus to finish that deck.

I might be hurrying to get done to get the bonus and then I make mistakes and I have to buy more materials. And now I have a cost overrun. There’s another type of contract. It’s a fixed price with an economic price adjustment. These are generally for long term contracts and we have a predefined financial adjustment. So what we’re talking about here could be a longterm contract. We’re buying a lot of materials as the vendor. Well, you have to accommodate things like inflation if there’s an obvious cost increase to my materials and I will adjust my price as well. If there is a decrease, then I’ll adjust that for you as well. It’s typically external conditions, things that the vendor does not have control over. So I’m building a skyscraper for you, and we’re buying a lot of steel for your skyscraper.

Well, the price of steel could fluctuate or inflation could go up or down. So it just accommodates those types of fluctuations in our project so that it’s fair to both parties because if it goes down, we’ll adjust it for you and how much you pay as well. Now, cost reimbursable contracts are generally not good for you. There may be some times where you want to do a cost reimbursable, but generally they’re not good. It’s a cost plus a fee. The scope of the work may not be defined early. So you do a cost plus. So there are instances where you’re kind of doing some research and development where you want someone to do some prototypes, make up three or four different solutions. So we’ll pay you for your time plus a fee for trying out these different prototypes.

So it’s kind of special why you would use one. Generally, though, you have a lot of risk as the buyer. When I am the seller with a cost reimbursable because I can run up the cost based on what I do, the buyer, you have the risk of cost overruns. All right, let’s look at a cost plus fixed fee contract. It’s all allowable costs, so all the materials. And then you’re going to have a fixed fee of the initial estimated cost. And that’s like I say, I’m going to charge $25,000 to create this piece of software. Plus you have to pay for buying the domain, and you have to pay for any of our server time, and you have to pay for transaction fees and so on. So it’s a fixed fee of the initial estimated cost, but also the work you’re going to pay. To us, the fee is constant.

You’re always going to pay the $25,000 you are paying. What fluctuates are those extras that we have there? So unless you add something to the scope, it’s $25,000 plus the cost. Really. Construction is a better example that you’re going to pay me $15,000 to build that deck on the back of your business. Plus all allowable cost. So permits, materials, anything that would paint varnish, whatever. If I break a hammer, you have to buy me a new hammer. So all allowable costs you have to pay. You’re always going to pay me a minimum of $15,000 plus the cost of materials. Now we talked about earlier a fixed price incentive fee. We could do a cost plus incentive fee. What this will allow are all of those allowable costs, all the materials and tools and so on.

But it’s a fee based on performance goals. So I have an incentive for you, for you to keep your cost down. And if you keep your cost down, you don’t have big overages, then I’ll give you a bonus. The contract will define what these measurements are. So let me show you what this looks like. Let’s say that this is our cost in the project. And here’s our timeline. And here’s that beautiful S curve, what we want to happen in our project. So our project is my company has borrowed $10 million from the bank, and we bought an old warehouse in the city, and we’re going to convert that to some condos until you finish. I’m hiring your company until your company finishes with the construction, then I’m losing money, really, because I have to pay the interest on that $10 million. So what we agree to is we set up some milestone targets. That’s the finish date right here of our project. And these are different phases. And here I’m just going to mark them like this.

These are different the end of different phases in our project. If you can get to these phases earlier than what we plan for and agree to, I will give you a bonus because that’s going to trend us towards finishing the project early. Remember, this is our time over here and this is our money over here. So if you can get to these milestones earlier than what was planned, that means we’re trending towards reaching the end of the project earlier than what we anticipated. So that means I can start selling these condos and paying the bank back faster and save on my interest.

So I’ll do a cost plus incentive fee. Or what I’m going to give you is for whatever these different milestones are. And we’ll do some math of what these milestones are worth. I will save X amount of dollars from the bank, and I will give you 20% of whatever I save on that interest as a bonus. So the earlier that you get done, I’m going to give you a bonus based on what I’m saving in interest. For example, you can set this up to be whatever you want, but generally it’s tied to a cost savings of some sort. Like I’m going to pay X amount of dollars for your expertise in this building, but I’ll also pay for you got to pay for the labor as a cost plus. Well, if you get down early that I’m saving on labor was a bonus, I’ll give you 20% of the labor costs that we save.

But upfront, we have to define that in our contract. And usually it’s driven by these milestones, like in this beautiful chart that I drew here. So that’s a cost plus incentive fee. It’s like a bonus where I want you to get done earlier so that we can save money and I can get the project over with. The next one is a cost plus award fee. This one’s a little sketchy. What happens in this idea is all allowable cost. But I’m going to give you a bonus based on my opinion of how the project work. So you don’t really know how much the bonus is going to be because it’s a subjective review by me, the buyer, and I get to determine the bonus amount. So it might be $5,000, might be $50,000, might be $5. You don’t know. It’s some type of a bonus just based on how well the project went.

So it’s better than nothing. It’s better than a stick in the eye. But you don’t really know how much you’re going to receive with this contract type as the award. One of the most common contract types is a time and materials contract where the seller is paid an hourly fee and materials. So sometimes you have this for smaller projects where we’re going to do some network drops and we charge $125 per network drop. And then for two engineers on site to do that, it’s $50 an hour or whatever. So you get an hourly fee, but you also pay for those materials usually or almost always.

With not to exceed, you want to have or with time of materials, you want to have a not to exceed clause, meaning that you can do this work that we’ll pay materials, we’re going to pay for your time, but we put a cap on it and not to exceed of $10,000. And then it’s also a time limit that this thing doesn’t last forever, that it’s going to expire within like 90 days or something as our contract is done. Generally for smaller projects, it’s a quick solution. It’s a time of materials contract.

Okay, good job. Know these contract types for your exam. Know the different reasons why you would use one or the other. Stay away from cost plus if you can, let’s keep moving forward. In the next lecture, we’re going to talk about should you buy or should you build?