Contract Types and Risk Risk is uncertainty, can be good or can be bad.

The traditional concept of risk is that it is always negative, and that is perhaps confusing yo u on such questions. First of all, whenever you see the word risk in any PMP question, substitute it with uncertainty to eliminate the confusion created by the traditional definition. Now regarding the questions addressing the risk shared by buyer and the seller by the means of a contract type, we have to determine who is more uncertain regarding the procurement arrangement. First lets address the basic categories and then I will go into the sub-categories. The three basic contract types are; Fixed Price Contracts, Cost Reimbursable Contracts, and the Time and Materials Contract. Fixed Price Contract: Remember that every contract has two most important driving factors, i.e., the price and the scope of work. Also the price hits the buyer, whereas the scope of work hits the seller. Since the price is fixed in the fixed price con tract, the uncertainty is not with the price, so the buyer doesnt have any uncertainty on its part. If the scope of work was not studied in a greater detail earlier, and during any point in time mor e work or effort is required to complete the contracted work, this would hit the seller and the uncertainty lies with the seller. Hence fixed price contracts are more risky for the sellers. Cost Reimbursable Contract: In cost reimbursable arrangement, all the price of work complete is invoiced to the buye r. The total cost of the arrangement is always uncertain to the buyer till the job is complete. On the other hand, the seller is certain that all the costs will be borne by the buyer even if the scope of work was not negotiated earlier, so there is no uncertainty on the sellers part. Hence the cost reimbursable contracts are more risky for the buyers. Time and Materials Contract: Time and Material are a hybrid type of contractual arrangement that contain the aspects of both cost- reimbursable and fixed-price contracts, so the risk is balanced between the buyer and the seller. Now lets look are the sub-categories. Firm Fixed Price Contracts (FFP): In Firm Fixed Price Contracts, the margin (fee) is fixed. Any change in effort or work will directly hit the seller. The sellers risk is at maximum over here. Fixed Price Incentive Fee Contracts (FPIF): Although the price is fixed, the sellers margin is a bit variable. The seller will be rewarded by a higher margin based on t he performance. Still since the price is fixed, the seller is at risk (its a fixed price contract after all) but in comparison with the firm fixed price contracts, the risk is lower for the seller. Cost plus Fixed Fee Contracts (CPFF): The risk for the buyer is maximum over here since all the costs will be reimbursed plus a fixed fee will be paid to the seller regardless of the performance. Cost plus Incentive Fee Contracts (CPIF): Although all the costs will be reimbursed to the seller, the sellers fee (or margin) will be dete rmined by the performance. This places a slight control over the arrangement. Again, since its a cost reimbursable contract, the risk lies with the buyer, but in comparison with the CPFF contract, the buyers risk is lower. Note: Please note that incentive in the fixed price arrangement, reduces the risk of the seller. While the incentive in the cost reimbursable co ntract, reduces the risk of the buyer. Dont associate the risk of either the buyer or the seller to the work incentive. Rather associate the word incentive with reduced. If the incentive is with the fixed price contract, the risk is reduced for the seller. If the incentive is with the cost reimbursable contract, the risk is reduced for the buyer. Remember this thumb-rule: Fixed price Cost reimbursable No incentive/fixed fee Incentive

Sellers risk Buyers risk Pure risk Reduced risk

Lets combine all of this information into a list of contract types ordered by the reducing level of risk for the seller: 1. Firm Fixed Price Contract 2. Fixed Price Incentive Fee Contract 3. Time and Materials Contract 4. Cost Plus Incentive Fee Contract 5. Cost Plus Fixed Fee Contract (Sellers maximum risk)

(Buyers maximum risk)