TYPES OF CONTRACTS
by LeRoy H. Graw
EdD, CPP, CPPM, CPCM, CISCM, CIPTC
Types of Contracts
Basic Objectives: After Completing the course, participants will be able to:
1.apply pricing policies to determine sources of fair and reasonable prices;
(1) identify and describe various types of contracts authorized by the regulations; and
(2) determine which type of contract is most appropriate for a particular procurement.
Table of Contents
CHAPTER I INTRODUCTION
What is Meant by 'Type of Contract"
The Nature of Fixed-Price Contracts
The Nature of Cost-Reimbursement Contracts
Comparison of Fixed-Price and Cost-Reimbursement Contracts
Contract Type and Pricing
Statutes and Regulations
Advantages of the Firm-Fixed-Price Contract
Fixed-Price with Economic Adjustment
Advantages and Disadvantages
Fixed-Price Incentive (FPI) Contracts
Description (Firm Target)
Fixed-Price Incentive (Successive Targets)
Application and Limitations
Advantages and Disadvantages
Fixed-Price Redeterminable Contracts
Fixed-Price with Prospective Price Redetermination
Fixed-Ceiling-Price with Retroactive Price Redetermination
Fixed-Price, Level-of-Effort Term Contracts
CHAPTER III COST-REIMBURSEMENT TYPE CONTRACTS
"Best Efforts" and the Cost Estimate
Allowable Cost and Fees
Why Use Cost-Reimbursement Contracts?
Limitations on Use
Types of Cost-Reimbursement Contracts
Completion Form versus Term Form
Fee Adjustment Mechanics
Comparison to Fixed-Price Incentive
Award Fee Mechanics
Comparison to Cost.-Plus-lncentive-Fee Contracting
Application to Other Contract Types
CHAPTER IV INDEFINITE DELIVERY CONTRACTS
The Indefinite Delivery Principle
Using Indefinite Delivery Contracts
Standards for Use
Estimated, Minimum and Maximum Quantities
CHAPTER V TIME. AND-MATERIALS AND LABOR-HOUR CONTRACTS
Description and Application
Typical Applications to Purchasing Organization Contracts
The Labor Portion - Hourly Rates
The Materials Portion
Basic Provisions for Materials
Alternate Provisions for Materials
Limitation on Total Cost
CHAPTER VI SELECTING THE APPROPRIATE CONTRACT TYPE
Policies Concerning Contract Type
Negotiating Contract Type
Factors in Selecting Contract Type
Uncertainty and Cost Risk
Knowns and Unknowns
Identifying the Affected Cost Elements
The Impact of Unknowns on Cost
The Degree of Control
Selecting Appropriate Contract Types Based on Risk
Factors Related to Pricing
Period of Performance
The Nature and Extent of Subcontracting
Technical Capabilities and Financial Responsibility
Supplier Accounting Systems
CHAFTER VII THE IMPACT OF CONTRACT TYPE ON ADMINISTRATION
Differences in Contract Clauses
Cost Reimbursement Payments
Time-and-Materials and Labor-Hour Payments
Inspection and Acceptance -- Fixed-Price
Inspection and Acceptance -- Cost. Reimbursement
Inspection and Acceptance -- Time-and-Materials
Termination for Convenience
Termination for Default -- Fixed-Price
Termination for Default -- Cost-Reimbursement
Termination for Default -- Time-and-Materials
Other Differences in Contract Administration
Contract Modifications and Changes
Purchasing Organization Property
Use of Purchasing Organization Supply Sources
CHAPTER VIII SPECIAL TOPICS
Purpose of this Chapter
Limitations and Clauses
Description and Purpose
Procedures and Limitations
Examples of Basic Agreements
Basic Ordering Agreements
Description and Purpose
Procedures and Limitations
Orders Under Basic Ordering Agreements
Examples of the Uses of BOA's
The Limitation of Cost Clause
Purpose of the Clause
Mechanics of the Claus
Cost "Growth" versus Cost Overruns
Terms of the Contract
Reviewing Claims for Reimbursement
Importance of Cost Review
Partial and Progress Payments
At the conclusion of the course the student will be able to:
(1) Apply pricing policies to determine sources of fair and reasonable prices.
(2) Identify and describe various types of contracts authorized by the regulations.
(3) Determine which type of contract is most appropriate for a particular procurement.
(4) Discuss the reasons for having different contract types.
(5) Identify the two basic classifications of contract types.
(6) Briefly give an overview of the regulatory and statutory foundation for contracting.
(7) Describe the features of a firm-fixed-price contract and its use.
(8) Explain economic price adjustments and the application to Purchasing Organization contracts.
(9) Discuss "risk sharing" as it applies to a fixed-price-incentive contract.
(10) Calculate the final cost, profit and price relationships for sample fixed price incentive contracts.
(11) Define a fixed price redetermination contract.
(12) Explain the conditions and restrictions on the use of cost-reimbursement contracts.
(13) Identify the difference between fixed and incentive fees and between objective and subjective incentives.
(14) Distinguish among the three types of indefinite delivery contracts with an emphasis on indefinite quantity and requirements.
(15) Identify instances where indefinite delivery contracts are appropriate.
(16) Describe both the time and materials, and labor-hour contracts to include their application.
(17) Highlight the contract clause used to explain both materials reimbursement and the limitation on total cost.
(18) Demonstrate an understanding of the nature of each contract type discussed thus far by highlighting the key distinctions.
(19) Identify those factors in the requirements or situation which impact on type of contract chosen.
(20) Cite the responsibilities of contract personnel as they pertain to the negotiation of contract type.
(21) List three factors that are inherent to the selection of contract type.
(22) Explain the rationale used in the formal analytical structure for selecting contract type.
(23) Explain how the choice of contract type can affect many aspects of the contracting process, give examples of contrasting contract types.
(24) Detail the limits and applications of letter contracts.
(25) Describe two forms of agreements.
(26) Distinguish the difference between a Basic Agreement and a Basic Ordering Agreement (BOA) and the limitation of the BOA.
TYPES OF CONTRACTS
A.What is Meant by "Type of Contract"
Within the environment of contracting, many distinctions are made among contracts. Distinctions are sometimes based on the nature of the work to be performed (Supply Contracts versus Construction Contracts); sometimes they are based on the method of award (Sealed Bid versus Negotiated Contracts). These distinctions have an important part in the acquisition process. But the critical distinction -- which forms the basis for this text -deals with the compensation arrangements between the Purchasing Organization and the Supplier.
This is the meaning of "type of contract" upon which one must focus. It is clearly an important distinction to both sides. Suppliers take Purchasing Organization work because they wish to earn a payment -- the basis by which it is decided that a payment is due is obviously important to them. The Purchasing Organization places contracts because it wishes to have work done to meet a mission need -- the amount to be paid and whether the Supplier is required to continue work toward meeting the need are obviously important to it. How these crucial items are defined under a Purchasing Organization contract is the heart of this text.
But in addition to the basic distinctions based on compensation arrangements, there are other related aspects of contracts which must also be covered. Various contractual devices can be used to define the quantity of work which the Supplier is required to provide (i.e., indefinite delivery contracts); other devices can be used to partially define the terms of work (Basic Agreements and Basic Ordering Agreements). These topics will also be covered in this text.
The selection of the type of contract to be used has a profound effect on all other aspects of the acquisition process. The method of contracting to be used may be a function of contract type; the clauses to be used are based on contract type; the pricing approach and other aspects of Source Evaluation are affected; and nearly all aspects of contract administration differ when various types of contract are used.
This text will:
a.define the available contract types;
b.discuss how the appropriate type is selected;
c.indicate differences in contract clauses used;
d. illustrate how contract administration is affected by the contract type selected; and,
(1) show how other aspects of the acquisition process depend on the selection made.
Compensation arrangements between the Purchasing Organization and Suppliers can take many forms. But the major distinction is between two broad categories of types of contracts: Fixed-Price and Cost-Reimbursement. An appreciation of this basic difference is needed for an understanding of the detailed information on the variations within these basic groups of contract types.
1.The Nature of Fixed-Price Contracts
The key element in every contract which is in the fixed-price family is that the Supplier is required, as a condition of payment, to successfully complete the work called for by the specification or work statement.
There are a variety of fixed-price types of contract. These will be discussed in more detail in Chapter II. The differences among the types relate both to the certainty of the final amount which will be paid (i.e# some fixed-price contracts do allow for adjustments in the price) and the time at which the final amount is determined. Keep in mind, however, that every fixed-price contract contains within it the guarantee of successful performance as a condition of payment.
This point can be illustrated by thinking of a simple equation between the work called for ("requirements") and the payment to be made ($$$). If the Supplier completes its side of the equations then the Purchasing Organization must come forth with its side:
Requirements = $$$
Even when adjustments to the amount are allowed, or when the amount of the payment is not defined until after contract performance is begun# this equation must be satisfied.
2.The Nature of Cost-Reimbursement Contracts
The key element in every contract which is in the cost-reimbursement family is that the Supplier is required, as a condition of payment, to make a good faith attempt (provide its '#best efforts") to complete the work called for in the specification or work statement. In a cost-reimbursement contract, the Supplier promises to make an effort to successfully complete the work within a certain limit of expenses. So long as the effort is made, the Supplier will be reimbursed for the money spent trying to meet that goal. The basic payment is made for the effort -- not for the results. Successful performance is # a condition of payment although it may have an effect on the amount of profit which a Supplier earns as a result of the contract.
There are a variety of cost-reimbursement types of contract which will be discussed in more detail in Chapter II. The differences among the types relate to profit (which is called "fee").
There is an equation to be considered for cost-reimbursement contracts. But the Supplier's side is now "effort" which must be balanced against the payment to be made ($$$). If the Supplier completes its side of the equations then the Purchasing Organization must come forth with its side:
Effort = $$$
This is a much different equation than the one defined for fixed-price contracts. The Purchasing Organization is, naturally, seeking to have its mission needs met; but those needs (the "Requirements" side of the fixed-price equation) do not even show up in the cost-reimbursement equation. This aspect of cost-reimbursement contracts accounts for the proportionately greater level of effort by contracting personnel required in both the placement and administration of a cost type contract.
This is not to say, however, that a cost-reimbursement contract is a blank check. The payment ($$$) side of the equation includes some safeguards. First, there is a limit on how much effort the Purchasing Organization will pay for (the l-imitation of Cost Clause as discussed in Chapters VI and VIII) before the Supplier should cease attempting the work. Secondly, only allowable costs are reimbursed as defined in the contract.
Nonetheless, there is quite a difference between a "safeguard" and a "guarantee". When any type of cost-reimbursement contract is used, the only thing guaranteed to the Purchasing Organization is that the Supplier will be paid -- not that any useful results could be achieved through the contract.
3.Comparison of Fixed-Price and Cost-Reimbursement Contracts
The primary purpose for having a variety of different types of contracts is to provide a means for allocating the risks of performance between the parties. The reason for having as many different variations as are discussed in the following Chapters is to fine-tune that risk allocation in such a way that the Supplier is effectively motivated to provide satisfactory work to the Purchasing Organization.
Look at the difference between the two equations again. There is always a chance that something can go wrong during contract performance. In the fixed-price contract, the Supplier's side is the Requirements. If something goes wrong, the Supplier must still meet the need as defined in the specifications. The majority of the risk thus falls on the Supplier.
In a cost-reimbursement contract, the Supplier's side is "Efforts". If something goes wrong, the Supplier will continue to make an effort. Thus, even if the problem is not corrected for cannot be corrected), the Supplier has fulfilled its side of the bargain and the Purchasing Organization must make payment. The majority of the risk thus falls on the Purchasing Organization.
This difference between the two families of contracts has a number of consequences. For example, awards in Sealed Bidding are a function of the lowest ultimate expense to the Purchasing Organization. Clearly this requires some form of fixed-price contract since the final amount to be paid is never guaranteed under a cost-reimbursement contract. Not even every fixed-price type of contract can be used in Sealed Bidding. The main point here is not precisely which types can be used but rather that the source of the regulatory restriction is not some arbitrary decision -- it is a necessary consequence of the nature of the contract types themselves. Similarly many of the clauses used apply only to one family of contract types and may not be used with the other. These differences are a direct consequence of the difference in the Supplier's sides of the two equations. Further, consider how contracts are administered: where the Purchasing Organization bears the risks associated with performance problems, it is clearly necessary to exercise closer scrutiny of how the work is being performed.
C.Contract Type and Pricing
One consequence of the difference between the families of contract types deserves explicit consideration at this point: the approach to determining what is a fair and reasonable amount is also driven by contract type.
Two general approaches to pricing are available: Price Analysis and Cost Analysis.
There are several forms of Price Analysis. But each of these forms applies the same principle of comparing the total amount to be charged by the Supplier with some standard which is itself considered to define what is reasonable under the circumstances. For example, if the basis for analysis is a catalog or market price, the comparison is between the offered price and prices currently for recently) paid for essentially the same item or service by commercial concerns. The preferred sort of price analysis is an even simpler comparison among the prices offered or quoted for the contract by firms in competition with one another for the contract.
Cost Analysis, on the other hand, requires a review of an of offeror's estimates of the costs which will be incurred during contract performance. In Cost Analysis, one must break the work down into its component parts and assess the reasonableness of the level of resources for labor, materials, and overhead support) which the Supplier claims are needed to do the work and the unit costs for each type of resource needed.
The degree of confidence which can be placed in each type of analysis is also a function of the type of contract to be used. When a cost- reimbursement type contract is employed, the amount offered by the Supplier does provide any guarantee that the final amount paid by the Purchasing Organization will be anywhere close to the amount shown in the proposal. Remember where the risks are placed. Thus it becomes necessary to use the techniques of Cost Analysis to determine what is a reasonable cost estimate. But where a fixed-price contract is to be used, the Supplier has made a guarantee of success with either a firm or a ceiling price). Even if the precise amount is not known, there is at least a range within which the final amount will fall. Thus it is possible to use Price Analysis with greater confidence.