Contracting Approaches

In addition to the general types of contracts there will also be variations based on the contracting approach. Most contracting approaches are driven by several factors:

1. Schedule. How important is the schedule for the work to be performed or product to be delivered?
2. Management resource availability. Do you have the resources needed to manage the work and are you prepared to commit those resources to manage performance and cost?
3. Budget. How important is it to manage the cost of the work?
4. Economic changes. Who should be responsible economic changes that occur that can affect the cost of the work?
5. Incentives.  Do you need incentives to drive the right behavior or desired performance?
6. Risk / cost allocation. Who should bear the cost or risk? The buyer, the supplier or should there be a sharing of the risk?

In an individual contract these factors will drive the type of contract approach you will use. There are a number of variations to the approaches and each variation has their own advantages and disadvantages, each will impact one or more of these factors differently. You can also have contracting approaches where over the course of the contract the parties can agree to implement a different model. For example, work started as time and materials or cost plus could be agreed to become a Guaranteed Maximum Sum or Fixed Price after the scope of all the work is fully defined.  Here are a few different approaches to contract types:

Time and Materials.

Rates for time are usually all-inclusive and include the suppliers charges for overhead and profit, Rates for materials and subcontracted work are normally cost plus an agreed percentage of the cost.

Time and Materials, Not to Exceed

Rates for time are usually all-inclusive and include the suppliers charges for overhead and profit, Rates for materials and subcontracted work are normally cost plus an agreed percentage of the cost. Not to exceed requires work to stop before exceeding the amount but does not guarantee completion.

Time and Materials Guaranteed Maximum Sum

Rates for time (labor) are usually all-inclusive and include the suppliers charges for overhead and profit, Rates for materials and subcontracted work are normally cost plus an agreed percentage of the cost. Guaranteed maximum sum requires all work be completed for that maximum amount. This means the amount could be less than the Guaranteed Maximum Sum, bit no more than that amount.

Cost plus fixed fee.

Usually has all work subcontracted and Supplier is paid for the costs of all subcontracts plus their fixed fee to manage the performance of the work,

Cost plus incentive fee

Usually has all work subcontracted and the Supplier is paid for the costs of all subcontracts plus their fee, which may be adjusted if they meet certain performance criteria such as schedule or cost.

Cost plus incentive fee (where incentive fee may adjusted)

Usually has all work subcontracted and the Supplier is paid for the costs of all subcontracts plus their fee, which may be adjusted at certain intervals based on performance.

Guaranteed Maximum Share Savings Contract

Usually has all work subcontracted and the Supplier is paid for the costs of all subcontracts plus their fee up to a Guaranteed Maximum Amount, where savings from that Guaranteed Maximum are shared to drive cost reduction performance.

Fixed price, or lump sum

Supplier will provide the products or services for a set price, subject to only changes to the scope of the product or work

Fixed Price with incentive fee

Supplier will provide the products or services for a set price, subject to only changes to the scope of the product or work but can earn additional incentives by meeting goals such as schedule or cost goals.

Fixed Price with General Economic Adjustments

Supplier will provide the products or services for a set price, subject to only changes to the scope of the product or work and general cost changes such as increased union labor rates

Fixed Price with adjustments due to changes in costs

Supplier will provide the products or services for a set price, subject to only changes to the scope of the product or work except for certain pre-agreed areas for adjustment such as changes in fuel charges, raw material surcharges.

Fixed Price with Cost Sharing

Supplier will provide the products or services for a set price, subject to only changes to the scope of the product or work except for certain pre-agreed areas where they parties agree to share in the cost. For example an agreement with a Band Width for currency exchange changes has the parties sharing in the costs within the band and price will only be adjusted if the currency exchange rate falls outside of the agreed bandwidth.

Percentage of Cost.

These may be used for service type contracts where the cost of the work the Supplier performs is closely related to the cost of another set of work being performed. For example Architects commonly want to charge a fee that is based on the percentage of the cost of construction of what they designed.

Here’s a general summary of the different approaches looking at the individual factors

Contract Type	Schedule	Resources	Budget Management	Economic Changes	Incentives	Risk Allocation
Time & Materials	Fast	High	Requires resources	Buyer Risk	None	Buyer Risk
T&M not to Exceed	Fast	High	Only sets cap before Additional Authorization	Buyer Risk	None	Buyer Risk
T&M, Guaranteed Maximum Sum	Reduced speed to establish GMS	Reduced	Establishes Max cost	Supplier risk to manage GMS	Only to manage to GMS	Buyer as to cost in general, Supplier for GMS
T&M with sharing of savings	Fastest	High	Resources required	Buyer risk	Dependent on share driving Behavior	Buyer
T&M with sharing of cost risk	Reduced speed to negotiate sharing	Reduced	Resources required	Shared risk	Supplier has incentive to manage against cost	Mixed
Cost + Fixed fee	Fastest	High	Resourced required	Buyer risk	Supplier has no incentive	Buyer risk
Cost + incentive fee	Reduced to negotiate fee	High	Resourced required	Buyer risk	Supplier may have incentive to earn fee	Buyer risk, supplier only risk is earning fee
Cost + sharing of savings	Reduced to negotiate Sharing	High	Resources required	Buyer risk	Supplier may have incentive to Generate savings	Buyer risk, supplier loses only share of savings
Cost + sharing of cost risk	Substantially reduced to negotiate risk sharing	Lesser	Lesser resources Required	Shared risk	Supplier has incentive to manage cost	Buyer as to cost in general, supplier as to shared
Fixed Price / Lump sum	Longest	Small	Low	Supplier risk	No incentives	Supplier
Fixed price incentive fee	Longest	Small	Low	Supplier risk	Depends of if incentive will drive behavior	Supplier, incentive fee must be earned
Fixed price Economic adjustments	Longest	Small	Less only review adjustments	Buyer risk	No incentive	Mostly supplier Except for adjustments
Fixed Price Cost Adjustments	Longest	Medium	Less only review adjustments	Buyer risk	No incentive	Mostly supplier Except for adjustments
Fixed Price sharing savings	Longest	Small	Requires managing sharing	Buyer risk, shared savings	Depends on if sharing will drive behavior	Supplier
Fixed price sharing of cost risks	Longest	Small	Requires managing sharing	Shared	Mutual	Mostly Supplier Buyer share in cost risks
Percentage of Cost	Reduced time, compare versus T&M	High	Resources required	Buyer’s risk	None for Buyer, Supplier makes more as cost increases.	Buyer
Fixed Price, Committed reductions	Longest	Low	Low	Supplier	None	Supplier

For incentives such as sharing of the savings or paying incentive fees or any remedies included in the specific agreement, it’s always important to determine whether the value you receive is worth paying the extra compensation. It’s also important to structure the incentives in a manner that will drive the desired performance. Otherwise the incentive won’t work and the Buyer will need to invest more resources in managing the activity. Another important point with incentives is all incentives need to be carefully structured to ensure that you aren’t paying incentives without getting the corresponding value. To do that the Buyer needs to be able to act freely and in the Buyer’s own best interest so you avoid situations where the Supplier could claim that they would have done what was required for the incentive payment but for the actions of the Buyer and as such should be paid the incentive.

Adjustments need to be closely managed and can require substantial work to track and manage.  The wildest one I ever had to manage dealt with a construction contract in Brazil during one of their periods of hyperinflation. Inflation was running at close to three percent a day or ninety percent (90%) a month. All payments had to be adjusted for inflation depending upon when the payment would be made versus the total amount of inflation that had occurred from the original date of the contract. It also required that we negotiate which inflation index would be used (as there were at least 3) and contractors would not agree to use only the Government published index as they felt it always understated the inflation. In the end we agreed to a blend of multiple indexes. It’s the only contract I’ve ever negotiated where the value of the monthly invoices in the last few months of the work were greater than the initial contract amount simply because of inflation and the compounding effect it had on the cost. 

Each approach will have some unique terms that are required.

That means that the focus of the negotiations will be different. For example: On a time and materials approach you will focus on negotiating individual rates, mark-ups, overhead, profit percentages. You will also seek to include terms relating to how the process will be managed. If you have multiple different classes of workers with different rates for each, you would want to include contract language to ensure that 1) the individuals warrant the rates charged (have the right skills and experience), 2) the work is assigned to the right level of individual (you don't want to pay for a senior person to do the work that a junior or entry level person may do), 3) the individuals assigned have the right skills and experience for the work (you don't want for them to learn at your expense), 4) there are controls over the work in the form of budgets and approvals to exceed budgets.

On a Management Contract you will focus on negotiating their fee; the reimbursable expenses that will be allowed versus what should be included in their overhead and profit; the mark up allowed for any of the subcontracts. You would also include language which identifies the process which will be followed regarding bidding of the subcontracts, selection of potential suppliers, subcontract terms, etc.

On a Full Bid/RFP you will be focused on negotiating: the total price; the costs of changes; the cost of unit prices for additional work; the cost of any pre-defined alternatives or options. The critical parts of this form of agreement are changes (both additions to, or reductions of scope, delays), performance and acceptance criteria, management tools needed to manage performance, and termination. 

On a 2 step approach, the 1^st phase approach will be closer to time and materials. The 2^nd phase approach will be the same as a full Bid/RFP.

Which approach should you use?

The decision will be driven primarily by the schedule and costs or losses that will be incurred if delays occur. For example, you buy a franchise for a McDonalds and rented store space at $10,000 a month commencing immediately. Once you open you will generate $200,000 a month and your expected profit is 20%. You then have to decide which contracting approach you will take. You can have the lowest cost risk with a lump sum bid, but that will take 2 months to design, two to three weeks to bid, and another 12 weeks to be constructed with all the equipment installed. If you take the fastest approach which is time an materials it will save one month on the schedule. A month is worth $10,000 in rental payments and a loss of sales of $200,000 that means a loss of expected profit of $40,000. Faced with these facts, you probably would consider alternative contracting approaches that are faster, but have more risk, rather than wait. In the end, there by trading the faster schedule and potential cost impact versus risk. You might settle on an approach which blends a number of the approaches such as  hire someone to do demolition of the space to prepare it for construction on a time and materials basis, purchase your equipment and fixtures on a competitive bid basis, hire a management contractor to manage the construction.

Different industry / commodity requirements create the situation where there is no one contract or procurement strategy that meets fits all needs. In the development of appropriate strategies there are a number of variables to be considered.

·       The commodity being purchased will identify the inherent risks or liabilities that will be involved with the purchase.

·       The nature of the purchase, such as whether it is a standard product, unique or custom will have an impact.

·       The demand for the purchase (such as whether it’s a one tine purchase or there will be on-going purchase needs) will impact strategies

·       Schedule and time available for delivery of the product, software or service may drive strategies.

·       Whether the Supplier would be the only source, the primary source, a second source or there would be multiple sources of supply.

·       The Financial impact of the different strategies on budget and cost will always be considered.

·       On-going service or support needs will drive contract strategies.

·       Each alternative strategy may require different commitments of time and resources to properly manage, and that will need to be weighed against the time and resources available to manage performance.

·       The Supplier or suppliers selected and their experience, reputation, prior history, and their management tools may drive what strategies are feasible.

·       The Buyer’s ability to make changes to the strategy over time, may further impact the procurement and contract strategy you select

The Impact on Contract Terms

Each of the variables that will drive the procurement strategy and the contract strategy may also drive what specific terms may be required in the contract.The commodity being purchased will identify the inherent risks or liabilities that will be involved with the purchase and those inherent risks or liabilities will drive terms that are needed to manage the, The nature of the purchase, such as whether it is a standard product, unique or custom will have an impact will drive what terms may be needed to manage the performance. For example if you are buying something that is unique or custom that may require negotiation of who owns certain rights in the development, what’s required for managing performance such as milestone schedules, reviews, approvals, submittals. The demand for the purchase (such as whether it’s a one tine purchase or there will be on-going purchase needs) will impact strategies. On-going needs will require contracts, that facilitate easy ordering and the same terms over the life of the demand and will need to address how pricing will be managed in the future

Schedule and time available for delivery of the product, software or service may drive strategies. For example, a contract for a time and materials approach to the work will require far more terms for control of the cost than a lump sum contract.
Whether the Supplier would be the only source, the primary source, a second source or there would be multiple sources of supply. The more you are dependent on one supplier, the more your contract will require protection against the Supplier doing things or having events that could impact you and your continuity of your supply or their providing service to you. 
The financial impact of the different strategies on budget and cost will always be considered.  Contracts for strategies that have the potential higher financial risks for the cost of the work will require more controls over how those costs can be accrued and must be managed.  For example, if you had a management contract where the Supplier was to manage all the subcontracting and was paid on a cost plus basis, you would need to establish all the things they would be required to do to manage the cost on your behalf.  You also do not want to reward them for doing a poor job in managing completion by continuing to pay their management expenses after the work should have been completed.
On-going service or support needs will drive contract strategies. If there are going to be service needs, your contract will need terms to ensure that 1) you get the needed service and 2) the cost for those services remains competitive as on-going service may be a key part of the life cycle cost of the purchase.
Each alternative strategy may require different commitments of time and resources to properly manage, and that will need to be weighed against the time and resources available to manage performance. If you will spend significant resources to manage the work, your contract will need to provide you with the tools necessary for your resources to be able to do their job. If you will spend few resources, your contract needs to make the supplier fully responsible to manage performance and have adequate remedies if they fail to perform.
The Supplier or suppliers selected and their experience, reputation, prior history, and their management tools may drive what strategies are feasible.  What you know about the Supplier should be used to determine what if any unique requirements you might want to place on the supplier. If you’ve had problems in the past or are aware of a problem, your contract should include terms to manage against those problems to drive the Supplier’s behavior and performance.
The Buyer’s ability to make changes to the strategy over time, may further impact the procurement and contract strategy you select. The more you may be locked into using a specific supplier where it would be difficult or costly to change suppliers, the more you need commitments from that Supplier that they will perform and behave in a manner that won’t negatively impact your business. For example if it was easy to change Suppliers, you might not care who they used as their subcontractors as if you didn’t like a change you could buy from someone else. If it were difficult or costly to change, you would probably want stricter control over their subcontracting as that could impact their quality or performance.