You’ve heard about so many different types of contract pricing models!
Time and material, fixed-price, milestone-based payment and more.
What are the different types of contract pricing models out there?
This article will answer just that!!
In this article, we will look at contracts such as firm-fixed-price-contracts, lump-sum contracts, cost-reimbursement contracts, cost-plus-award-fee contracts and more! We have put together the most recurring type of contract pricing models out there.
This article is divided into the following sections:
- What is a Contract Pricing Model?
- Fixed-Price Contract (FP)
- Firm-Fixed-Price Contract (FFP)
- Fixed-Price Contract with Escalation (FFE)
- Fixed-Price Incentive (FPI)
- Lump-Sum Contract (LS)
- Time and Material contract (T&M)
- Cost-Reimbursement Contract (CR)
- Cost-Plus-Fixed-Fee (CPFF)
- Cost-Plus-Incentive-Fee Contract (CPIF)
- Cost-Plus-Award-Fee Contract (CPAF)
- Unit Pricing Contracts (UP)
- Milestone Pricing Contract
Let’s get started!
What is a Contract Pricing Model?
The contract pricing model is the way you will structure your contract price and payment paraments.
There are many contract pricing models out there.
We have identified the most popular one so you can get a better sense of the different contract pricing models out there.
Fixed-Price Contract (FP)
A fixed-price contract is a contract where you will define a definitive and fixed price for the services or the work that you will perform.
What’s important in a fixed-price contract is that you properly scope the services you will render.
Any services required outside of the scope of a fixed-price contract will require a separate agreement to be signed by the parties.
Firm-Fixed-Price Contract (FFP)
A firm-fixed-price contract is a type of contract that shifts the maximum level of risk onto the vendor and the minimum risk onto the customer.
In this type of contract pricing model, the contract provides for a price that is not subject to change no matter the vendor’s cost experience during the performance of the contract.
The project cost risk is therefore fully assumed by the vendor.
Fixed-Price Contract with Escalation (FFE)
A fixed-price contract with escalation is a type of contract that will fix the price of the service to be rendered with a possibility to revise the pricing upwards if certain price fluctuations defined in the contract were to occur.
This type of contract pricing is used when the delivery of the services will span over a few years potentially having an impact on the market costs and expenses.
The possibility of ‘escalating’ the price is a protection given to both parties in case there is an important change in labour or material cost.
Fixed-Price Incentive (FPI)
A fixed-price incentive contract is a type of contract pricing model where the contract provides for a fixed-price while allowing an adjustment to the final contract price based upon an agreed formal taking into account the final negotiated cost and the total targeted cost.
In essence, this type of contract will provide a financial reward or incentive to the seller for the defined criteria related to its performance.
Both seller and buyer stand to gain in this type of contract.
To start with, the seller will give a very reasonable price to the buyer having the ability to benefit from the incentive should the seller’s performance meet or exceed the success criteria in the contract.
If the seller succeeds, then the price may go up to the benefit of the seller.
On the other hand, the buyer benefits from a very reasonable price upfront and even if the price goes up based on the contractual criteria, the buyer will still be happy as the seller did an amazing job.
So the increase in price will be justified.
Lump-Sum Contract (LS)
Lump-sum contracts is very typical in construction contracts where the parties will agree on one lump-sum for the entire work before the work begins.
A lump-sum contract can work well for both parties when the scope of the project is well defined and it’s unlikely that the scope changes significantly.
The contractor will be able to set the lum-sum price based on the effort needed for the project.
The contractor will take on more risk as there may not be many contractual mechanisms to vary the price based on cost and actual work performed.
Time and Material contract (T&M)
A time and material contract involves one party paying for the work or services as the work is getting done.
The customer plays a more important role in the actual project and carries all the risk related to change of scope.
Depending on the responsibilities and scope defined in the contract, the service provider will render its services by charging for the time of its personnel and the costs incurred.
This essentially shifts the project risk from the vendor to the buyer.
Cost-Reimbursement Contract (CR)
A cost-reimbursable contract is a variant of a contract that involves a reimbursement payment from the buyer based on sellers actual costs.
The seller will usually add a fee or a percentage charge associated with the administration of that cost.
The costs must necessarily be incurred by the vendor in regards to the project.
This type of contract is also sometimes called a cost-plus contract.
A cost-plus-fixed-fee contract is a type of contract where the contractor is paid for the normal expenses for the project along with an additional fee for the services rendered.
This type of contract can result in the contractor not having any incentive to control the cost of the project as this cost will be reimbursed by the client in full.
As such, the initial price negotiated may be drastically different than the actual costs.
If the contractor has a good control on the project costs, the final project cost can be lower than what was anticipated benefiting the buyer.
Cost-Plus-Incentive-Fee Contract (CPIF)
A cost-plus-incentive-fee is a type of contract where the cost of the project is reimbursed and the contractor can get an incentive-based on a formula defined in the contract based on the total allowable cost and the total targeted costs.
In this type of contract, the seller’s total profit will increase the more the actual project cost is below the targeted costs and the total profit will decrease if the actual project costs are above the targeted costs.
Cost-Plus-Award-Fee Contract (CPAF)
A cost-plus-award-free contract is a type of contract pricing model where the fee is based on the amount fixed at the inception of the contract along with a financial incentive or award based on defined contractual objectives.
This type of contract gives the seller the flexibility of earning a good profit when the work cannot be defined at the beginning of the project.
This type of pricing can be highly rewarding in a high-risk project.
Unit Pricing Contracts (UP)
Unit pricing contracts are based on estimated quantities of items or unit prices such as hourly rate, the rate per unit work volume or other metrics.
Typically, the vendor will price the unit in such a way that the overhead and profits are embedded in the unit price.
This type of contract works well when you know the resources that you need for a project but you are unsure for how much time or volume.
Engineering projects or construction project are suitable for unit pricing as you may know the cost of your personnel per hour but cannot fully estimate the total time spent until the end of the project.
Milestone Pricing Contract
A milestone pricing is a type of contract where the payment from the buyer to the vendor will be made based on concrete accomplishment or milestones in the project.
Software development contracts or construction contracts can be milestone based as the vendor or contractor will need to demonstrate that they have successfully accomplished a phase of the work as define dint he contracts to be entitled to get paid.
Typically, the buyer will make an initial payment to start the project and all subsequent payments will be made based on the accomplishment of milestones.
Contract pricing model takeaways
There are so many ways you can price your contracts.
Depending on your industry or the nature of the product or services you offer, you may want to evaluate a different type of pricing models to find the right balance between the risk and reward you will get.
In this article, we’ve offered you the most recurring contract pricing models out there.
We hope you enjoyed it!