Cost vs. Price: Examining 3 Types of Contracts in Facilities and Project Management
Editor’s Note: This article originally appeared on LearningFM’s blog.
Managing contracts in asset and facilities management is a delicate balancing act that directly impacts cost control, resource allocation, and operational efficiency.
From fixed-price agreements to cost-reimbursable contracts, every contract type has its own unique set of benefits, risks, and complexities. And understanding these differences is crucial for ensuring that facilities are managed within your budget while maintaining high-quality service.
By leveraging advanced features of asset and facilities management software – like cost tracking, forecasting, and reporting features – facilities managers can gain full visibility into contract performance, mitigate financial risks, and ensure that every contract is aligned with broader operational and financial goals.
Let’s explore the different types of contracts you may encounter and how asset management software can streamline the management of these contracts.
Fixed-price contracts
Fix-priced contracts have a clear statement of work, and the buyer accepts a seller’s price for it. In this type of contract, the seller bears the risk. An example of this is a purchase order, which establishes the price, quantity, and date for any deliverables.
There are three main types of fixed-price contracts:
- Firm fixed-price
- Fixed-price incentive fee
- Fixed-price with economic price adjustment
1. Firm fixed-price (FFP)
The most common fixed-price contract. A price is set from the outset and will not change unless there is a change in scope agreed upon by the buyer and seller.
2. Fixed-price incentive fee (FPIF)
In this type of contract, the buyer and seller share some risk and can both benefit from the seller out-performing agreed-upon metrics. With FPIF contracts, a ceiling price is established (the maximum amount the buyer will pay). Then both parties agree upon a target cost (FP) and the target fee (IF). Both added together become the target price.
Finally, each agrees to a share ratio of cost overruns or underruns. The share ratio then is used to calculate the point of total assumption (PTA), where the buyer stops contributing to cost overruns and all additional costs incurred come from the seller’s profit.
If that sounds confusing, just consider this example.
Let’s assume I want to purchase a custom piece of equipment that a contractor will make. We agree that I will pay no more than $125,000 for this piece of equipment and that it should cost the contractor $100,000 to make. We agree that if he can make the equipment for that, he deserves a $10,000 incentive fee, which means I would pay the price of $110,000. It looks like this:
Target Cost – $100,000
Target Profit – $10,000
Target Price – $110,000 (target cost + target profit)
Ceiling Price – $125,000
Next, assume we agree to an 80/20 share ratio. That means that if the contractor is able to make the equipment for less than $100,000, his profit goes up by $.20 for every dollar he saves. Alternatively, any costs beyond $110,000 will be paid 80% by me and 20% by the contractor, which eats into his profit. It looks like this:
Share Ratio – 80% buyer, 20% seller
At some point, because I’m not paying any more than $125,000 total, the share ratio goes to 100% contractor and 0% me. This is the PTA and is calculated like this:
PTA = ((ceiling price – target price)/buyer’s share ratio) + target cost
PTA = (($125,000 - $110,000) / 0.8) + $100,000
PTA = $18,750 + $100,000
PTA = $118,750
Therefore, once costs go above $118,750, the contractor incurs 100% of them. The contractor can still make a profit (up until the cost reaches $125,000), but each additional cost takes away from it.
3. Fixed-price with economic price adjustment (FP-EPA)
This is the third type of fixed-price contract and is used for contracts that span multiple years.
Cost-reimbursable contracts
These contracts first reimburse the seller for all actual costs incurred and then add a fee for the seller’s profit. In this type of contract, the majority of the risk falls on the buyer and is less desirable because of it. These types of contracts are more appropriate if there’s not a clear statement of work at the beginning of the project during the negotiation process or when there are risks too high for the seller to accept at a fixed price.
There are several types of cost-reimbursable contracts:
- Cost Plus Percentage of Cost (CPPC) – In this type of contract, the seller bears zero risk and the buyer accepts it all. This is the least desirable cost-reimbursement contract for the buyer since all costs incurred by the seller are reimbursed plus a percentage of them. An unethical seller might be tempted to not control costs, as they should, since their profit increases as the cost increases.
- Cost Plus Fixed Fee (CPFF) – Here, the buyer still bears all risk, but the seller’s profit does not increase as costs increase. The profit is set at the beginning of the project (typically a percentage of the estimated costs) and does not change unless the scope changes, regardless of the seller’s performance.
- Cost Plus Award Fee (CPAF) – This contract shares the risk a little more with the seller. In the CPAF contract, the buyer reimburses the seller for the actual costs and then awards a fee based on the buyer’s satisfaction of performance standards outlined in the contract.
- Cost Plus Incentive Fee (CPIF) – This contract shares the most risk between buyer and seller of the cost-reimbursable contracts. In the CPIF contract, the buyer reimburses the seller for actual costs and then pays an incentive fee that’s predetermined and outlined in the contract based on the seller achieving certain objectives.
Time and materials contracts
T&M (time and materials) contracts are a hybrid of both fixed price and cost-reimbursable and are used when a clear statement of work cannot be generated. An example of this is using set professional hourly rates (for instance attorney fees) when the scope (number of hours the buyer will need) is unclear. It’s always a good idea to establish a ceiling or a not-to-exceed (NTE) price in this type of contract to avoid massive cost overruns.
Conclusion
Understanding the different types of contracts in asset and facilities management is essential for controlling costs and ensuring efficient resource allocation. By utilizing asset lifecycle management software, managers can gain critical insights into contract performance, track expenses in real-time, and make data-driven decisions that keep projects on budget and aligned with strategic goals.
Learn why a CMMS is essential for managing costs and see why Brightly solutions can help your organization reduce costs and improve long-term financial planning.
