The contracts a business signs with its customers can be the difference between making or losing money, as the contract terms will govern the scope of the project and how much the business will be paid for completing it. While many contracts are individually negotiated and thus unique, most can be grouped into several categories: fixed-price contracts, cost-plus contracts and variations on these.
What is an advantage of a fixed-price contract? Fixed-price contracts offer both the buyer and seller a clear idea of the price. They also tend to be fairly straightforward to administer.
What Is a Fixed-Price Contract?
Fixed-price contracts, also known as firm-price or lump-sum contracts, are agreements in which the two parties state the goods or services one party will provide and establish the price the other party will pay for them. In some ways, they’re similar to the prices of goods at the grocery store. The amount indicated on a loaf of bread is the price the consumer pays — with the addition of taxes in many cases.
Fixed-price contracts tend to be best suited for when a project’s scope can be clearly determined upfront, and the costs of the materials and labor needed to meet the contract’s terms can be estimated with reasonable certainty. The amount paid to the seller won’t increase, even if more materials or time are required than initially estimated.
What is a fixed-price contract example? A simplified version of a fixed-price contract could look like this:
Project: Develop logo for Tree Lovers Orchard
Vendor: JDK Creative
Due Date: Two weeks (Due. March 1)
Notice, the contract doesn’t discuss the steps JDK Creative will take to develop the logo. That’s because no matter how many steps are needed, the price remains $2,000.
However, they’re often not this simple. There are usually other sections such liability, terms for terminations of contracts, delivery, payment terms etc. For example, they may include penalties for a late termination and benefits for terminating early — construction companies often use terms like these to help ensure that the project is completed within scope and on time.
The primary advantage of fixed-price contracts is certainty in terms of accounting. Once the contract is signed, all parties understand the products or services to be delivered or performed and the amount of money that will exchange hands.
Another consideration when setting up contracts is payment terms. Not only can it affect the cash flow of your business, but there are also other tax and compliance issues to keep in mind. For example, if your company follows accrual-basis accounting, revenue will be recognized when it’s earned — or when your business performs the actions that entitles it to incur the revenue. This means even if payment is handled before the project begins or comes in well after it’s complete, the revenue will be recognized in the period it is earned. If you follow cash-basis accounting, this will not be the case. Regardless of your processes, it’s important to include in your contract when payment will be rendered, and then plan accordingly.
Fixed-Price vs Cost-Plus Contracts
Cost-plus contracts, sometimes referred to as cost-reimbursement contracts, differ from fixed-price contracts in several significant ways. Under a cost-plus contract, the buyer reimburses the seller for the actual costs incurred, plus an additional amount for managing the project and profit — that’s the “plus” in “cost-plus.”
Cost-plus contracts generally are best suited for when it’s difficult to accurately estimate the project scope at the outset.
The costs included in a cost-plus contract typically include the labor and materials directly used in the project and indirect costs like insurance. If the project requires more materials or labor than expected, the price will increase accordingly. Cost-plus contracts offer sellers some guarantee of profit, even when the project’s scope isn’t known at the outset.
The additional amount for project management and profit can be calculated as a set fee, on an hourly basis or as some percentage of the project cost. For cost-plus contracts to work as intended, the seller needs a robust project accounting system that can accurately track direct and indirect costs devoted to a project.
In a cost-plus contract, the buyer takes on more risk, as the final project cost isn’t established at the outset. Some buyers may worry they’re essentially handing the seller a blank check.
However, buyers can benefit under cost-plus contracts. For one thing, they offer a level of transparency, as the seller typically must submit records showing the costs they’re incurring for labor, materials and other items. And because the seller knows their costs will be covered, they have less incentive to cut corners.
Cost-plus contracts can be quicker to implement. That’s because it’s not as critical that all elements of the project be pinned down ahead of time, as is prudent with fixed-price contracts.
Moreover, a cost-plus contract can ultimately cost buyers less than a fixed-price contract. The reason? Under a fixed-price contract, the seller typically charges more to cover the risk they’re assuming.
To provide some certainty under a cost-plus contract, the parties can agree that the final project total can’t exceed a certain amount.
What is the difference between a fixed-price and cost-plus contract? With a fixed-price contract, the seller takes on the risk of executing the contract for a set price, even if their costs increase. With a cost-plus contract, vendors charge for the costs they incur and an additional amount to cover managing the project and allowing for profit. This transfers the risk that the project will be more expensive or time-consuming than initially estimated from the seller to the buyer.
Types of Fixed-Price Contracts
The United States Federal Acquisition Regulation (FAR) is the body of laws that govern the U.S. Federal Government’s procurement process. Among the types of contracts the government uses are the following:
Firm fixed-price contracts: The seller in these contracts must deliver the products or services as indicated in the contract and at the price established. These agreements don’t allow any wiggle room. Should sellers need to expend more time or money than they anticipated, they will make less profit than expected. To provide themselves a cushion, some sellers charge higher prices than they would under cost-plus and similar types of contracts.
Firm fixed-price contracts tend to be best suited for straightforward projects in which costs are well known in advance. One example would be the delivery of 100 gaskets in two weeks.
Fixed-price incentive contracts: In this variant of a fixed-price contract, the company providing the product or service can receive more payment if it exceeds the contract requirements. This could come into play if, for instance, a contractor finishes a construction project ahead of schedule.
Conversely, the incentive can be negative. That is, a penalty can be levied if the seller fails to meet the criteria established in the contract.
Fixed-price contracts with economic price adjustment: Fixed-price contracts with economic price adjustments, or FP-EPA, allow for an adjustment to the agreed-upon price if certain criteria are met, such as changes in the prices for materials and labor or to account for inflation. This adjustment reduces the risk the seller assumes in a pure fixed-price contract.
To minimize the risk of misunderstanding, all parties should explicitly identify the criteria under which an adjustment is allowed. For example, some FP-EPAs use publicly available indices, like an index of fuel prices, to guide the adjustments.
Because FP-EPAs allow for adjustments to the contract price, they’re often suited for contracts that extend for multiple years.
Cost-plus-fixed-fee contracts (CPFF): Buyers reimburse sellers for allowed costs at a predetermined rate. These tend to make sense when it’s difficult to estimate in advance all costs required to execute the contract. This often is the case when a project involves new technology or research.
For CPFF contracts to work as intended, the seller needs a project accounting system that enables them to track and segregate the material, labor and other costs relevant to the project.
Fixed-ceiling-price contracts with price redetermination: Fixed-ceiling-price contracts with price redetermination include a ceiling price, which is the maximum the firm will pay. Contracts with prospective redetermination set a firm fixed price at the initial period of the contract, and at a stated time during subsequent periods are open to be redetermined. These are used when it’s possible to negotiate the price for the initial period of the contract, but not for future stages.
Contracts with retrospective redetermination allow price adjustments after the contract is completed. They’re generally used for research and development contracts in which it’s difficult to establish a fair price upfront.
When Should Fixed-Price Contracts Be Used?
No one contract type is right for every project, and all types have pros and cons. Fixed-price contracts tend to work best when the project’s cost can be determined in advance with confidence. In general, these projects:
- Are simpler, encompassing a limited number of products and/or services.
- Include deliverables that are well known and perhaps repeated; an example would be the delivery of ten reams of computer paper each week.
- Use materials and labor for which prices are fairly well known in advance.
- Have only limited performance uncertainties.
To be sure, some customers may insist on a particular type of contract, essentially forcing the vendor to either go along or lose the business. No matter the type of contract, both parties should understand all the nuances before signing.
When should a fixed-price contract be used? Fixed-price contracts tend to make the most sense when a project is relatively simple and the costs of completing it can be confidently estimated in advance.
Advantages & Disadvantages of Fixed-Price Contracts
Advantages: Fixed-price contracts provide certainty, as both sides have a solid understanding of the price and the products or services to be delivered. They tend to be easier to administer, as they require less tracking of labor and other materials than typically is the case with other types of contracts, such as cost-plus.
Of course, the company selling the product or service still will want to track the resources it’s devoting to the project so that it can calculate its profit or loss. In fact, fixed-price contracts provide the seller an incentive to closely manage costs and schedule to minimize the risk of losing money on the deal.
Disadvantages: While fixed-price contracts can be simpler to manage, they come with risks. Most notably, the seller takes on the risk that unforeseen obstacles might arise, requiring more time and/or resources than were accounted for in the terms agreed to. The seller will still have to meet the terms of the contract, even when doing so eats into budgeted profits. Because of this, many sellers set a higher price than they might with cost-plus contracts.
Managing Fixed-Price Projects
The following steps can help sellers effectively manage a fixed-price contract and mitigate the risk they assume:
- Assess whether it makes sense to enter into a fixed-price contract with the client. Can you be confident of your ability to deliver according to the terms? How likely is it that the project will follow the project plan? If the project is fairly set — say, providing cleaning services once a week — the risk of deviation is low. Projects that are less defined, such as launching a new food brand, are inherently riskier.
- Identify all buyer and seller responsibilities, including the timeframe and the products or services to be delivered.
- To the degree possible, identify all steps and materials required to complete the project.
- Estimate, as accurately and thoroughly as possible, the costs of these steps and materials. This includes all types of labor and materials required and the amount and cost of each.
- Estimate indirect costs, such as management oversight time.
- Total all estimated costs.
- Identify possible disruptions. This could include an unexpected increase in materials costs or a delay in a critical part.
- Calculate the amount you’ll add to the contract to cover this risk. This typically will require balancing the risk of unexpected obstacles with the need to provide a competitive price.
- Outline a process for handling changes.
- Once the project is underway, monitor the work against the schedule and budget.
- Schedule regular meetings with the customer to ensure the project is meeting expectations.
Handling Changes to Scope of Work
As projects get underway, it’s not unusual for the scope or direction to change. While this may be normal, it also can disrupt the agreed-upon schedule and budget and reduce the seller’s planned profit.
A change order process helps to manage changes to the scope of work. This should describe who can sign off on changes. Generally, it should be someone at a managerial level who can identify the impact the change will have on the overall project.
Before agreeing to the change, identify the impact on the schedule and budget. Work with the buyer to determine how the change will be reflected in the budget and schedule.
List the change itself and the impact on a change order and have all parties sign off on the order.
Note: Avoid using the profit and/or contingency built into the initial contract terms to accommodate the project’s changes. These amounts are intended to handle unexpected obstacles that might arise rather than changes to the project itself.
Managing Fixed-Price Contracts With Accounting Software
The right accounting software can help any business better track and manage its work and expenses on fixed-price contracts. Project accounting software helps you with each step of the process, from managing expenses to recognize revenue and automated billing. By understanding your costs with accounting software, you’re better able to forecast costs and generate quotes for fixed-price contracts. Additionally, the software gives you real-time insight and reporting so you can view projected versus performance for each contract or your business as a whole.
Another helpful tool with project accounting software is what’s sometimes known as the renewal pipeline. This helps you better understand the status of renewals, what revenue is generated, upsells and returns for your contracts. Additionally, depending on your accounting structure — accrual or cash-basis — revenue recognition may need to be accounted for differently and accounting software helps you stay compliant and accurate.
The most suitable contract type will vary for each project, depending on its scope and risk, the degree to which costs can be confidently estimated in advance and the relationship between the parties. While sellers generally take on more risk with a fixed-price contract, they also can reduce this risk by outlining all steps and materials required and including a contingency amount. No matter what type of contract governs a project, all parties should have a solid handle on terms and responsibilities.