The Money Files

Last time I looked at the three general types of contract that you often find on projects: fixed price, cost-reimbursable and time and materials. That’s the overview, but as you’d expect with all things budget related, there’s a lot more to it when you start to dig into the detail.

Let’s look in a bit more detail at cost-reimbursable contracts. Personally, this is the type that I find the most confusing. Fixed price (you pay what both parties agree) and time and materials (you pay for the work done at the vendor’s agreed rates) are pretty straightforward, but cost-reimbursable contracts are harder to get your head around in my opinion.

There are four types. You’ll find the most common three in A Guide To The Project Management Body of Knowledge (PMBOK Guide) – Fifth Edition, each with a snazzy acronym:

Cost Plus Fixed Fee (CPFF)

All allowable costs (that’s whatever you’ve defined in the contract) get reimbursed. Then on top of that the vendor gets a fixed fee extra payment. This is determined at the beginning of the project, normally calculated as a percentage of the project cost. Note that this means it will be based on the estimated overall project cost, so if your costs go up significantly they won’t get any more (although they will probably ask for this to be renegotiated).

Cost Plus Incentive Fee (CPIF)

All allowable costs get reimbursed. Then there’s an incentive paid based on whether the vendor has hit certain performance targets. The theory behind this is that the vendor will try extra hard to meet your needs to earn that performance bonus. The risk is that you set the performance targets against things that are too easy to achieve or too difficult to measure and you end up paying the maximum when you don’t feel as if they have really earned it.

The other twist with this type of contract is that if the project goes over the original agreed budget then you will split the extra charges with the vendor. You’ll agree the amount of the split in the contract (it’s unlikely to be 50/50). This works both ways, so if the project is under budget, you’ll give some extra back to the vendor as you’ll split the saving with them as well. It’s another incentive to do well and to keep costs within budget.

Cost Plus Award Fee (CPAF)

Again, all allowable costs get reimbursed. Then there’s an extra payment, but it isn’t as clearly worked out as in the other two cases. There are performance criteria for the vendor to achieve, and these are documented in the contract, but they are more subjective. The total fee available as an award is negotiated and documented in the contract so the vendor knows the maximum that can be achieved. Then the project team determines how good a job the vendor has done against set criteria and then determines how much of that available fee the vendor will actually get. They can’t dispute the award, so if it is lower than they would have hoped, that’s tough, and they may actually get nothing if the project team consider that their work has not been satisfactory.

These types of contract are used extensively by NASA. As they say in their contracting guidelines, you can’t standardise the performance factors. What’s important on one project is not important on another: early delivery of a weather satellite might be good to help monitor natural disasters more quickly, but early delivery of a planetary probe means nothing because the window to launch it only occurs every couple of years. Therefore in that case early delivery may actually cost money as the probe would have to be stored somewhere. Performance measures should be tailored to the contract and project and, as the NASA guidelines recommend, based on outcomes not outputs.

The final cost-reimbursable contract doesn’t get used much according to Wikipedia. It’s:

Cost Plus Percentage of Cost

In this contract, the allowable costs are covered as you would expect, and the vendor also gets a payment based on those costs. This is calculated as a percentage of their overall cost. So, as they spend more, their fee goes up. See the problem? There’s no incentive to keep costs low. It’s also not that attractive to project teams who have to pay the increasing costs, plus the increasing contractor fee. It’s not surprising that this type of contract is specifically prohibited for U.S. government procurements (its banned in 16.102, the section on Policies if you want to confirm this for yourself, on page 403 of a 1889-page Federal Acquisition Regulation document, or you could just trust me!).

So those are the 4 types of cost-reimbursable contracts. You probably won’t come across all of them, but it’s good to know that they are out there in case you ever do need to use them or a supplier tries to get you to go for one and you aren’t convinced it is the right thing for your project. As with all procurement matters, get specialist help if you are dealing with contracts and legalities: it is very easy to tie yourself and your company into a contract that isn’t clear and that doesn’t serve your best interests so if in doubt, get your in-house counsel to look it over.

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.

Your project plan is made up of lots of different elements, and cost management is one of those. When you’re planning your project, your cost management plan sets out the processes required to make sure that your project hits its budget targets.

Your cost management plan should include these items:

1. Process descriptions

What processes are you doing to be using on the project for cost management? These include planning, estimating costs and how you will establish the overall budget. Add in some detail about what processes you’ll be following and where these can be found, for example if you intend to do bottom-up estimating or bypass the standard cost planning process on advice from your project accountant.

2. Accuracy levels

How accurate do you intend to be? Of course it would be great to say that you’ll be 100% accurate in all your estimates, but that’s unrealistic! State here what you are aiming for. You can also add that this will change as the project progresses. For example, you will start the project with lower accuracy targets because you won’t have as much information as you will later on. Then as you get further into the project you can amend your estimates with the latest, more accurate figures. Set out here whether you intend to do that and how you will go about doing those revisions.

3. Variance thresholds

What variance is going to be acceptable before you have to flag a problem to your sponsor? Talk to them about how much leeway you have in your measurements and when they expect you to be bringing them issues. You may find that they are prepared to give you quite a big bracket either side of your target before it becomes a problem.

Set out the percentage deviation from each of your major measures such as baseline budget so that you know exactly where your boundaries are.

4. Performance measurements

If there are any specific rules for performance measurements, make a note of them in this section of the cost management plan. This is particularly relevant if you are following Earned Value processes. If you aren’t, you’ll probably find that you don’t need this section. If in doubt, talk to your Portfolio Office about what they expect to see.

5. Units of measure

How are you measuring things? It might seem obvious to you that ‘25’ refers to days of effort, but someone else could read that as hours of effort and come to a very different conclusion! Specify how you will be measuring time and budget figures. This is especially important if you are working in multiple currencies as you’ll need to specify that here.

6. Reporting protocols

When are you reporting? How frequently? Who to? These are all questions to answer in the reporting section of your cost management plan. Agree the format of your plans with the project sponsor and anyone else who will be receiving them. Then set out exactly how often you’ll produce these reports. It is also worth including what you’ll put in them so that there are no surprises. It can be difficult to gather new data items once the project has started if you haven’t built in a way to record them, so get a clear idea now about what your stakeholders want to see.

7. Anything else

Finally, don’t take this list as the only items to be included in your cost management plan! Your Portfolio Office may have other ideas and your corporate template may require you to complete other sections. Even if it doesn’t, you can still amend your document and add in anything else that will help you manage costs on this project – be flexible, even if you use a template.

Other things that may be useful include roles and responsibilities of those involved in cost management, a note referring back to any criteria set out in the business case, a link to any corporate policies that you will be following or any critical dates such as end of year reporting timelines or reforecasting milestones.

Your cost management plan should give you a working document to help manage spending on your project, so make it work for you and adapt any template (and this list) so it is a practical, comprehensive guide for everyone on the team.