#PM Cost Management—Cost Risk

Cost risk is a concept of the cost management knowledge area that touches upon the knowledge areas of risk and procurements. This is because it refers to which party, the buyer or the seller, is at risk of bearing the additional costs if the cost of the goods or services ends up being more than the amount agreed upon in the procurement contract.

Here’s a chart comparing the three main types of procurement contracts:

Procurement Contract Explanation Cost risk Main use
1. Fixed Price (FP) Buyer pays seller a fixed price for producing goods or services Seller Well-defined scope and resource requirements
2. Time and material (T&M) Buyer pays seller on a per-hour or per-item basis Seller/Buyer Scope defined, but resource requirements uncertain
3. Cost reimbursable (CR) Buyer pays seller costs incurred for producing goods or services Buyer Scope uncertain

Here’s an explanation of why the cost risk is listed as in the above chart:

1. Fixed Price (FP)

Let’s take an example of a fixed price contract where the buyer agrees to pay the seller $5000 for producing a component that the buyer needs to put in the product it is manufacturing. If the actual costs for the seller producing the component end up being $6000, and the seller is still paid only $5,000 by the buyer, this means the seller loses $1,000 in profit on the contract.

So the seller will usually want to see the scope defined in the statement of work to be as clearly defined as possible, and the resource requirements to also be clear to the seller in order to control the cost risk. In this way, the seller will know whether the company can produce the goods or services for a profit or not.

2. Time and material (T&M)

Here the cost risk is somewhere in between that of a fixed price and cost reimbursable contract because the price per hour or per item is fixed, but the amount of resources required from the seller is unknown. The buyer will want to put limits ahead of time on the amount of hours or items it will agree to pay for in order to limit its cost risk.

3. Cost reimbursable (CR)

If the scope is uncertain, especially in cases where the buyer is creating some new product it has never produced before, the cost reimbursable contract is probably the type the seller would prefer because if the costs end up being higher than anticipated, the buyer will pay for those additional costs. Here it is the buyer who will want to define in the contract as clearly as possible what the allowable reimbursable costs are in order to control the cost risk.

Because of the asymmetrical risk between the buyer and seller, they can end up working at cross purposes. Therefore, there are systems of incentives which can be added to the basic contract types in order to make the interests of the buyer and the seller more nearly coincide. The details of these subtypes of contract under the three basic types listed above will be taken up in the posts on the Procurement knowledge area.

The next post will deal with the elements of the cost management plan.

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