CONTRACT TYPE AND LIABILITIES

Introduction

A contract is a legal obligation between two or more parties and can either be oral or written. The making of a contract involves one person making an offer and accepting the offer and consideration often in terms of monetary terms. Consideration is where both parties provide something of value in exchange for a benefit. Procurement is the purchasing of products and services from an outside source; thus, organizations outsource some projects as they focus on the core business. The external parties enter into a contract with the client to provide services and sign a contract to bind the agreement legally. There are three main types of procurement contracts; fixed-price contracts cost reimbursable contracts and time and material contracts. This essay looks at the cost-reimbursement contracts and risks incurred in such an agreement.

Cost Reimbursement Contract Characteristics

Cost reimbursement contract is a type of contract under which the contractor is compensated allowable and reasonable costs incurred in carrying out the work addressed in the terms of the contract (Eckerd and Girth, 2017). A supplementary fee is added to the cost of reimbursement and is usually stated as a percentage of the contract’s full price. The final price is determined after the end of the project or a stipulated date in the contract while an estimated total cost is determined before the project starts. It allows the agency to set a budget which the contractor is not at liberty to exceed without the owner’s permission. The contractor is, however, allowed to stop the project once the maximum budget limit is reached.

Cost reimbursement contracts allow the contractor to assume the risks of the project until completion. The assumption is that the contractor will deliver on the promise of completing the job; thus, the owner promises to pay a fee so the contractor can make a profit. This type of contract is applied where the range of the job is not accurately established at the start, and the risks associated with the job description are high. The allowable costs that are reimbursed are set out in the contract and must have documented proof regarding the costs. There are two categories of costs associated with the cost-reimbursement contract; direct and indirect costs. Direct costs refer to the costs incurred only for the project. They include labor, materials, and sub-contractors. Indirect costs refer to the general and spread costs across each department, such as administration and overhead costs.

After completing the project, the real cost is compared to the predetermined costs set out at the beginning of the job. In cases where the real cost is higher than the stated actual costs, the two parties in the contract agree to share the savings. A pre-agreed arrangement in the contract determines the basis of sharing. This serves as an incentive for the contractor. In projects where the real cost is higher than the set cost, the supplementary costs might also be shared. There are four categories of cost-reimbursement contracts; Cost Plus Fixed Fee (CPFF), Cost Plus Incentive Fee (CPIF), Cost Plus Awards Fee (CPAF) and Cost Plus Percentage of Cost (CPPC).

Types of Cost Reimbursement Contracts

In CPFF contracts, the contractor collects the reimbursement plus an established fee stated in the contract and does not change based on the real cost of the project (Marsh, 2017). The change in the predetermined fee is only viable when there is a change in the work to be completed. This type of contract is used in high-risk projects where few bidders keep the contractor safe from the associated risks that might outweigh any non-financial benefits.

CPIF contracts describe a contract where the contractor is compensated for all the costs incurred plus an adjustable fee. The fee is based upon the achievement of a predetermined objective. The incentive acts as a motivating factor for the contractor in completing the project efficiently. The formula by which the fee is adjustable is based on the comparison of real costs, target cost, and maximum or minimum fee. The higher the variations between the two costs, the lower the fee, and the lower the variations, the higher the fee.

CPAF contract is where the contractor receives compensation and a fee based on the evaluation of the performance. The fee is subject to the client’s subjective analysis of the project and is based on the satisfaction levels achieved. The award serves as a motivator for the contractor to be cost-efficient and produce quality results to the client.

In a CPPC contract, the contractor receives reimbursement on all costs incurred plus a percentage of the total cost. The higher the costs, the higher the profit, and vice versa. There are no set parameters to gauge the control of costs incurred in the whole project. The lack of incentives on the part of the contractor and the risk of inflated costs make the contract less utilized in procurement.

Risks Associated with Cost Reimbursement Contracts

The risks associated with this type of contract are high and often incurred by the client. There is a risk of cost control as the contractor is not motivated to be efficient in cutting costs below the maximum. The lack of cost-effectiveness leads to higher risks to the client as all the allowable costs are reimbursed (Kim and Brown, 2017). This risk is high due to the negligence the contractors portray as they are assured of profits at the end of the project. This type of risk leads to the client establishing a clear set of guidelines written in the contract, such as defined budgets in each particular department. Traditionally, this risk was mitigated by giving incentives to the contractor when the total costs are within a set parameter. However, the incentive can be used to present low-quality projects that do not meet the standards set. The use of austerity measures and oversight in the project’s costs can be utilized in the quest to minimize the risk.  The client can incorporate checkups in the contract regarding safety and quality project completion.

Estimation of costs risk happens when the contractor gives an understated guess estimate. The contractor has little incentive to give a precise estimate; thus, the client may have problems relating to the budget set. The planned client’s budget may not be at par with the costs incurred; thus may end up spending all the finances on a project that is halfway completed based on the contractor’s estimates. The lack of a guaranteed maximum price presents the client with financial problems as the costs continue to rise above the estimate.

Contractors in this type of contract often serve their interests first; thus, there is little motivation to negotiate for the best prices from suppliers. The risk of buying materials that have been inflated lies with the client as it is reimbursed as a direct cost. The subcontractors also increase the risk when they work at a higher rate than the standard, thus increasing the risk of cost overruns. Contractors can also charge double on administration expenses leading to an inflated bill to the owner. Another risk is the level of allowable costs concerning the project. The area of dispute in the contract comes in when the overhead and administration costs are not appropriately defined in the project; thus, the client is at the mercy of paying for all the costs.

There are risks associated with completing the project and after the final check where the product is faulty. The contract has no warranty claims or callbacks; thus, the risk is absorbed by the client. The warranty claims are associated with the agreement of another contract to correct the anomaly. The owner bears the most risks in this type of contract; hence, strategies should be put in place to protect the client from quack contractors and pass some of the risks to the contractors and subcontractors.

Risk Shielding Strategies

The risk regarding the cost-reimbursement contracts can be spread across to the contractors so that they retain some of the risks. These strategies include; putting a ceiling price on estimated costs, disallowing some costs, and cost-sharing (Mühlbacher, Amelung and Juhnke, 2018). The ceiling price strategy is where the contractor is paid for only the allowable costs below the set price. Costs that exceed the set price are not compensated; thus, the risk is passed on to the contractor.

The set price is included in the contract and is usually a percentage of the estimated price. The client can disallow some costs that inflate the overall cost, thus increasing the risk absorbed by the contractor. These may include home expenses and bonuses to home office personnel.  Cost-sharing is achieved when the contract has a clause in which the costs over a set target are shared between the client and contractor. Such a provision increases the risk borne by the contractor, thus limits the costs blowing over.

Usage in Government Agencies

Cost reimbursement contracts are used in government when there is uncertainty over the estimated cost of products or services throughout the contract. This is common in research and development departments where costs are not explicitly defined. The department of defense mostly uses this type of contract as it has predetermined limits to be achieved. The defense department spent nearly $160 billion in research and development in 2019, where most contracts were cost-plus contracts (Girth and Lopez, 2019).  The quality of the products is also a factor as the contractors are rewarded based on the quality in terms of incentives and awards. The contractors need not compromise on the quality of their products as there would be fewer constraints on the payment criteria.

 

 

References

Eckerd, A., & Girth, A. M. (2017). Designing the buyer-supplier contract for risk management: Assessing complexity and mission criticality. Journal of Supply Chain Management, 5

Girth, A. M., & Lopez, L. E. (2019). Contract design, complexity, and incentives: Evidence from US federal agencies. The American Review of Public Administration, 49(3), 325-337.

Kim, Y. W. & Brown, T. (2017). Autonomy versus control in procurement and contracting: the use of cost-reimbursement contracts in three US federal departments. International Review of Administrative Sciences, 83(1_suppl), 41-58.

Marsh, P. (2017). Contracts and payment structures. In Contracting for Project Management (pp. 19-31). Routledge.3(3), 60-75.

Mühlbacher, A. C., Amelung, V. E., & Juhnke, C. (2018). Contract Design: Financial Options and Risk. International journal of integrated care, 18(1).

 

 

THEORETICAL FRAMEWORK/MODEL FOR CONTRACT TYPE

[Week# 4]

 

 

Communication Plan

[Week#5 –  Include the Appendix A, ONLY, from the Appendix A—Communications commitments]