Contracts

11 October, 2013

Project managers who studied the 4th edition of the Guide to the Project Management Body of Knowledge (PMBOK® Guide) before taking the PMP® exam will remember contracts. However, project managers that focused on the 5th edition, their PMP® exam preparation will centre on agreements. Whatever, you call them, contracts or agreements are a vital component of project procurement management.

For organizations embarking on projects, project managers have to deal with make or buy decisions. Sometimes these are made on financial considerations. Is it cheaper to rent a piece of equipment for the duration of the project or is it better to buy it and use it for other projects or for sustaining operations?

Things get a bit more difficult when intangible factors like the organization’s knowledge base come into play. It might be cheaper to get a specialist company to develop some part of the project but it would be strategically beneficial for the organization to build up the knowledge and skills in house. Another factor that could influence the project manager’s decision is confidentiality. We might have some really special, proprietary parts in our product, but letting third-parties get involved could risk our intellectual property rights. In these cases, we might decide that security trumps efficiency.

Once the project manager decides to get a third-party vendor involved, s/he needs to ensure that the best possible one is chosen. Software companies that jumped on the outsourcing bandwagon and subcontracted large chucks to their development work to low-cost economies soon realized that they had added a tremendous amount of specification work to the project. When developing in-house, if a developer stumbles upon an incorrect or missing part of the specification, it is relatively easy to contact the designer and resolve the problem. However, in outsourcing arrangements, the specifications have to be perfect. Otherwise, the clarification process can slow work down considerably.

Cultural factors also played a part. In Eastern Europe, it was found that the engineers were very good at finding errors in specifications, but they tended to send them back to the customer for correction. In the Far East, they were inclined to implement what was asked for without question. So dealing with third-parties is fraught with risk.

Risk is certainly the motivation behind the different contract (or agreement) types. Both the buyer and the seller want the other party to bear the cost if anything goes wrong. The contract type agreed is often a subtle indication of the relative strengths of the parties involved. If the buyer is in a strong position (for instance a major supermarket purchasing meat products), the contracts tend to be fixed price. This arrangement means that the vendor has to make up the shortfall if there are any unexpected costs incurred.

However, even within a fixed price arrangement, there are contract forms that allow a certain amount of protection to the vendor. Obviously the “Firm Fixed Price” contract is not attractive, unless the vendor has the goods in stock and ready to ship. However, even then, the cost of shipping could spike between the contract being signed and the goods being delivered.

Customers can get around the lack of appeal of a fixed price contract by using variations on the theme. “Fixed Price with Incentive Fee” can entice a reluctant vendor if the incentive fee corresponds (or exceeds) the risk contingency put aside for the job. PMP® exam preparation students will remember the risk contingency calculations from the Perform Quantitative Risk Analysis process. Similarly, a long-term contract, where materials form the largest part of the budget, can be made attractive by offering a “Fixed Fee with Economic Price Adjustment”, so that increases in the cost of materials can be absorbed by the customer.

Vendors certainly prefer the “Cost Reimbursable” contracts. These are usually highlighted by government audits which show massive overspending on contracts. In its basic form – the “Cost Plus Fixed Fee” arrangement, the vendor has no incentive to seek efficiencies or do anything to control costs. The fee is the same no matter how long the project takes, or how much it costs.

A better arrangement is the “Cost Plus Incentive Fee”, where the fee is contingent on meeting certain targets. Often the incentive is expressed as a ratio. For instance, an 80:20 ratio means that the customer will get 80% of any underspend or pay 80% of any overspend, while the vendor is liable for 20%. This helps to prevent cost overruns.

Another attempt to control “Cost Reimbursable” contracts is the “Cost Plus Award Fee”. Here the customer can specify a set of performance criteria that have to be met before the vendor is paid. In this way, the customer can specify delivery dates, quality of goods and, of course, cost targets.

The final contract type covered in the Project Procurement Management section of your PMP® preparation course is the “Time and Materials” contract. Customers are understandably wary of these as, in principle, these contracts have no cost or schedule targets. Indeed governments have got badly burned with these contracts as well.

One development that can make Time and Materials contracts benefits the customer is Agile software. An interesting statistic is that over 60% of delivered software functionality is rarely if ever used. So a customer can find that the software product meets its needs long before the estimated end date. In this case, the Time and Materials contract favours the customer. However, when there is initial uncertainty about the scope or direction of the project, a Time & Materials project can give sufficient incentive for a vendor to bid on the work. Of course, make sure these contracts are not open-ended – set a ceiling on the materials costs allowed and an end date on the time. A good compromise is to offer a Time & Materials contract with the goal of clarifying the requirements and then move towards a more Fixed Price contract when the task becomes better defined.

Finally, no project management course would be complete without mentioning the legal aspects of a contract or agreement. Firstly both parties have to be legally competent – you cannot get your young children to sign a contract and sue them if they misbehave. Similarly, the contract has to relate to a legal purpose, so you cannot sue your drug dealer for selling you dope containing impurities.

Once these factors are in place, there are three components to a legally binding contract: 1. Offer (one party makes a bid for the work), 2. Acceptance (the other party formally commissions the bidder to do the work) and 3. Consideration (there must be an exchange of some sort – financial or otherwise).

Contracts (or agreements) are just one of many subjects covered in Velopi’s project management courses. Please check out our project management training offerings or contact us for more details. Velopi is a Registered Education Provider for the Project Management Institute and all our project management courses are aligned with the PMBOK® Guide.

By Velopi Seamus Collins
 

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