Understanding Different Contract Modalities Academic Essay – Write My School Essay

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Understanding Different Contract Modalities
Contracts can be configured in various ways, but most are divided into one of two categories: fixed price contracts (also
called lump sum contracts) and cost plus contracts (also called cost reimbursable contracts). Following is a summary
differentiating the characteristics of these two contract modes:
Fixed price contracts. Sellers agree to provide welldefined
goods and/or services by a specific date at a fixed price. Sellers
bear most of the risk on this contract, because if there is a cost overrun, the seller must assume the burden of the loss.
Fixed price contracts also have “opportunities,” because if the seller’s costs are very low, they have an opportunity to
increase their profits.
Cost plus contracts. Buyers agree to reimburse sellers for whatever costs they incur in carrying out the contracted work.
Clearly, buyers face a serious risk of cost overruns here, because if contractors spend too much, buyers are obliged to
reimburse them. In order to create incentives for buyers to save money, some variations on cost plus contracts have
emerged, including:
• cost plus incentive fee contracts (CPIF). With the CPIF contract, a table is created that shows how contractors can be paid
defined bonuses if they deliver their products early (e.g., $5,000 bonus if delivered one week early; $8,000 bonus if
delivered two weeks early).
• cost plus award fee contracts (CPAF). With the CPAF contract, a pool of award fee money (i.e., a bonus pool) is created. If
contractors do a great job on their contracts, an award fee panel may elect to pay them a bonus with money taken from the
award fee pool of money. Judgments of performance are subjective.
• cost plus fixed fee (CPFF). With CPFF contract, buyer and seller negotiate a fee (i.e., profit amount) that the buyer will pay
the contractor, given that work is completed in a satisfactory manner. The fee is negotiated before any work has begun.
Thus contractors know ahead of time what their profit levels will be. They have no incentive to increase costs in hopes that
that will lead to higher profit levels. CPFF contracts are the dominant contract mode for research and development projects,
which are high risks efforts.
A commonly employed variant of the cost plus contract is the time and materials contract. This is a cost reimbursable
contract where contractors are reimbursed for the time they put into a job plus expenses they incur in purchasing materials.
Unlike the cost plus contracts, there is no explicit “plus” associated with the contract. This does not mean profits cannot be
gained. If profits are factored into this type of contract, they must be built into the salaries and material costs associated with
performing the contract.
1. For the following types of undertakings, which contract modes are most appropriate? Be prepared to explain the
rationale behind your choice.
• We want to order a pencil manufacturer to produce 20,000 pencils for us
• We want to have a 300 meter bridge built to span a local river
• We want to have a contractor design a brand new circuit board that has stateoftheart
• We want to contract out work to operate our small factory