Project Management

Procurement Management 101: Three Types of Contract

From the The Money Files Blog
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A blog that looks at all aspects of project and program finances from budgets, estimating and accounting to getting a pay rise and managing contracts. Written by Elizabeth Harrin from GirlsGuideToPM.com.

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Categories: procurement


You can’t do many projects to change something without spending a bit of cash. And when money is involved, a contract is essential! Generally you’ll come across one of three types of contract on a project: fixed price, cost-reimbursable (also called costs-plus) or time and materials. However, the contract is for the whole deal, so if it makes sense to have some services from a vendor on a fixed price basis and others on time and materials, then the contract would include both these terms. You wouldn’t have a different contract for both elements simply because they were on different terms. There may be other reasons to have contracts for different terms but they are likely to be because the deal was agreed at a different date or similar.

OK, let’s take an example. You want to buy software consultancy and development services from a vendor. They will help you spec out the software so it is fit for use by the users, then they will build it. The requirements gathering part of this deal is on a fixed price basis. They know that it will take them 6 workshops and some prep time to prepare the complete requirements, so they can cost for that in one hit (fixed price). But they don’t know how long it will take to build the software, because they don’t have the requirements yet. If it’s a lot of work they want to be compensated, but they don’t want to overcharge you if it’s not much work, so they’ll price that based on the effort it takes (time and materials). They do know that there is a software licence that they will have to buy on your behalf, and you plan to pay them for this at the purchase price (cost-reimbursable). The one contract between your company and theirs will cover all these elements.

You choose your contract terms based on the best procurement arrangement for your company and theirs depending on what you both want to get out of it and making sure that everyone’s interests are covered. So let’s look at those three contract types in a bit more detail.

Fixed price contracts

With a fixed price contract the buyer (that’s you) doesn’t take on much risk. This is great for the project’s risk register, but not so great for the project budget. As the seller adopts all the risk they normally add a bit to the price to allow for any risks. For example, just because our software consultancy firm thinks it is going to take 6 workshops to define requirements because it has done on the last 10 occasions this doesn’t mean it actually will this time round. They have never worked in your industry before so they add enough into the fixed price proposal to cover them in case they have to do more.

What sometimes happens is that vendors want to win your business so much that they price too low. The problem there is that if something does go wrong and all the risk is on the vendor’s side, they then don’t have enough profit in the deal to make it worth their while, and they may even lose money by working on your project. If this happens then you should watch out – they may start to cut requirements or drop quality to try to claw something back.

However, the advantage for you with a fixed price contract is that you know exactly how much it is going to cost you before you begin the work, and for many project teams this is very valuable.

Cost-reimbursable contracts

With a cost-reimbursable contract you pay the vendor for the actual cost of the work. This could be materials, equipment, whatever and will normally include direct (e.g. salaries) and indirect costs (e.g. electricity for running the office). Indirect costs will be a fixed percentage amount – they won’t send you their electricity bills and ask you to pay a proportion.

So how does the vendor make any money? Obviously they aren’t working for you for nothing, and while you are covering all their expenses they want there to be some kind of financial return. The contract will include a clause that allows them to claim a profit over the cost price, either a fixed fee or some kind of incentive payment. It’s common, but if your vendor proposes this make sure you fully understand what you are signing up to.

Time and materials contracts

Time and materials contracts see the vendor being reimbursed for materials purchased plus a per day or per hour rate for time spent. The developers building the software in this example will charge on a time and materials basis. In this case, there probably won’t be many materials and they will charge their daily rate for time spent writing and testing the new product. They will act pretty much as if they are a salaried member of your project team, and you’ll have a fair amount of control over what they do (as you are paying for it, after all). They might ask you to sign timesheets or at least submit their own timesheets for your approval along with the invoice as proof of the hours spent working on your software.

This sort of contract is great for projects where you don’t know exactly what you want when you start out. Provided you keep a close eye on costs and manage the budget and the work so that you don’t overspend, this can be a really cost effective way to add more resources and skills to the team.

Which of these have you used on your projects? Let us know your experiences in the comments.

Posted on: May 20, 2014 05:26 AM | Permalink

Comments (6)

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Great information and very timely. I'm studying for my PMP and fo rsome reason the cost reimburseable contracts just weren't clicking.

sanban10
I am currently doing a digital project for a nutrition based company and the requirements are not very clear. So I am option for Time and Materials hybrid contract. What are your thought? The budget and the time is very unrealistic and constricted. However, I am preparing a detailed project plan PMP to educate the organisation about how to manage a not so well defined project. I am using PMBOK in conjunction with Agile and lean

Glad that the article helped you Sherryl.

Sanban, apologies for taking so long to get back to you. Time and materials sounds like a possibility for your situation. Do you have a legal or procurement team that you could take advice from?

When can we use a SOW contract?

Thanks for sharing, an amazing article!

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