Understanding Contract Price Type
Whether you are on the customer or supplier side, contract price types can often be misunderstood and not used to their full potential. It is important to understand the context of the engagement you are looking to contract, and the most appropriate price type to manage risk and incentivise performance.
It is also essential that your contract model allows for agility and change, as requirements / solutions and delivery environments change often, and the contract needs a workable mechanism to deliver fast, effective change without stifling performance and innovation.
Your contract price type is a key area of negotiation, both from a commercial contracts and pricing perspective. Without a clear view of the allowable costs within an open book model, suppliers run the risk of either not pricing all of their required costs, or under pricing and having to fund the delivery of contractual obligations.
There are a broad range of price types within contracts, and whilst this isn’t an exhaustive list it should give an overview of the most common contract price types and the best areas to use them.
- Time and Materials
T&M contracts are often used where requirements and outcomes are not accurately defined, and where a task is considered more “open ended” than a traditional specification-based model. Under T&M, the Contract Price is based on the actual cost of direct labour, materials and overheads. In this arrangement, direct labour is typically charged at hours/days x agreed rates plus the actual costs of materials and equipment usage. Then their may either be an agreed upon uplift to cover overheads and profits, or the contractor will accommodate this uplift within its charging rates.
A perceived advantage of the T&M model is that its flexibility is a benefit, and it is a mechanism for “getting stuff done” whilst providing the opportunity and ability to adjust requirements and shift direction. In reality, this flexibility can just as easily be implemented in a well written contract, and from a customer perspective T&M contracts present a risk as they can sometimes lead to poor requirements definition and poor design. It is always advisable to define the projects outputs beforehand. If T&M contracting is the right fit for your project, then it is recommended that you include a cap mechanism to ensure you are aware of your Not to Exceed position.
- Firm Price & Fixed Price
There is a lot of confusion in different industries and countries regarding the terminology Fixed and Firm Price, and the two are often used interchangeably with different understandings of the definition. For the purpose of this blog we will use the UK government definitions where:
- “Firm Price” – The Contractor undertakes the Contract for a total, all-inclusive price that will not change.
- “Fixed Price” – The Contractor undertakes the initial period of the Contract for a total, all-inclusive price that will not change. However, elements of the price may be varied after an agreed period using an agreed mechanism”
Therefore, a Firm Price contract is where the price is set and fixed (and adjustments do not apply). The only mechanism for changing the Contract Price would be through an agreed change control. Whereas a Fixed Price Contract is where the price is set and fixed, however adjustments can be applied in allowable circumstances as defined within the contract.
The main difference between the two is whether adjustments are contracted and there is a mechanism to treat these in the contract (such as inflation). As stated above the actual definition may vary dependent on your environment, so it is advised that you always understand the adjustments position contractually, regardless of your familiarity with pricing terminology. Where inflation is being contracted, it is always worth ensuring the agreed economic adjustment is appropriate for the context of your industry (see https://www.ons.gov.uk/economy/inflationandpriceindices) regardless of whether reviewing from supplier or customer side.
More generally, you should use fixed price contracts where the requirements and programme plan are clear, where there is a limited or fixed budget, or where there is a small project with limited project scope. Ultimately under a fixed/ firm price model the majority of risk lies with the contractor (who should price that risk accordingly). For more effective contracting it is recommended that risk lies where it is best controlled, and there is an appropriate commercial mechanism within the contract to treat this.
- Cost Plus Incentive Fee
Cost Plus Incentive Fee contracts are an advanced contract mechanism which require good commercial management skills and behaviours from both supplier and customers. This is an open book contract and when operated correctly, Cost Plus Incentive Fee contracts can lead to a better relationship between buyer and seller (because good performance and working together is rewarded) and enhance communication lines between parties as performance criteria will be accurately monitored.
Cost Plus Incentive Fee contracts consist of a base contractual fee (note, this can sometimes be zero, or may be zero until achievement of Gateway Service Levels) and an award fee determined by the achievement of specific milestones (or outcomes) as defined by the contract. This type of contractual arrangement allows the Supplier to be reimbursed for the costs of performing work and provides an incentive for the supplier to deliver excellent performance in accordance with the performance criteria stated in the contract. If the performance of the contract is at a lower threshold than expected, then the fee should be adjusted proportionately.
A more sophisticated application of this mechanism (and TCIC) would be where the outcomes / performance criteria are directly mapped to the customers budget position through conducting detailed analysis of the customers operating model and Target Operating Model. Performance Criteria can then be contracted and tracked against the actual quantifiable benefits delivered back to the customer.
- Target Cost Incentive Fee
Again, an open book contract, the Target Cost Incentive Fee (TCIF) mechanism is similar to a Cost-Plus Incentive Fee contract price type, however in a TCIF the performance criteria is often focused around cost reduction. It is a powerful mechanism for incentivising cost reduction and supplier performance. Increased fee levels are often paid to the Supplier on achievement of cost savings, and typically a “Gain-Share” ratio is applied. The share between the parties is dependent on the agreed negotiated positions of the respective parties.
On larger multi line multi year contracts, to ensure effective change management it is essential to have a robust cost / price baseline via your Contract Financial Model against which any change can be impacted. It is also recommended a similar level of discipline is applied to requirements to solution mapping to ensure a stable design / programme plan.
In UK Government, TCIF contracts are typically contracted as a MTCP (Maximum Price Target Cost) which caps the customers liability and means any cost overrun will fall to the contractor. Whilst principles can vary across price types, often in the Private Sector the terminology GMP (Guaranteed Maximum Price) is used, which is where the Supplier is compensated for actual costs, and the fee mechanism can vary from Fixed Fee, Incentive Fee or a Gain-Share mechanism.
- Cost Plus Fixed Fee
A cost-plus fixed fee contract price type is again an open book contract, however under this arrangement to contractor is reimbursed allowable costs (as defined within the contract) and paid a fixed fee for delivery. This is more appropriate for more transactional type contracting arrangements where output-based performance criteria are either already optimised via different mechanisms or where they are hard to define.
To learn more about Open Book Contracting, see https://www.commercial-consulting.co.uk/open-book-contracting.
If you have any further questions on price types, or require specific advice on a project, please contact us at firstname.lastname@example.org.