5th Edition PMBOK® Guide—Chapter 12: Cost-reimbursable procurement contracts

1.  Introduction

In the process 12.1 Plan Procurement Management, the organization looks to the company policies, procedures, and guidelines regarding the types of procurement contract that would be available and decides which type of contract would be best for the particular project at hand.  More than one type may be used, depending on the procurement involved.

In a previous post, I described the three basic types of procurement contract: a) the fixed price, b) the cost-reimbursable, and c) time & material.  The purpose of this post is to describe the various sub-types of the second type of contract, the cost-reimbursable procurement contract.  In general, this type of contract is used under two conditions:

  • The scope of the project is not precisely defined at the start, and will need to be altered in the course of the project
  • The project has high risks

Below is a summary of the three sub-types of procurement contract that fall under the general type called “cost-reimbursable” contracts.  In all three sub-types, the seller is reimbursed for all allowable or legitimate costs for performing the contract work.

Fig. 1  Cost-reimbursable Procurement Contract Subtypes

Cost-Reimbursable Contract Subtype Description Fee to seller is determined by …
1. Cost Plus Fixed Fee (CPFF) Seller receives a fixed-fee payment for completed work Fixed percentage of initial estimated project costs, and does not change.
2. Cost Plus Incentive Fee (CPIF) Seller receives an incentive fee for completed work; final costs over the initial estimated project costs are shared by buyer and seller based on negotiated cost-sharing formula. Incentive fee is fixed amount; but this may added to or subtracted from based on whether final costs are under or over the target costs (based on the original initial estimated project costs).
3. Cost Plus Award Fee (CPAF) Seller receives an award for achieving performance criteria agreed upon beforehand. Award is fixed amount as specified in contract, based on performance of seller.

Let’s take each of these contract sub-types in turn.

2.  Cost Plus Fixed Fee (CPFF)

The cost-reimbursable contract normally favors the seller, because all costs plus an agreed-upon profit margin are reimbursed by the buyer.  This type of contract protects the seller in the case that more work is required to handle an increased scope, so that the seller will not have to produce the product at a loss.  In general, the buyer is protected by the fact that only legitimate or allowable costs are reimbursed.  In this type of contract, the buyer will normally scrutinize the seller’s account of what the costs are to make sure of this.

By adding fees as incentives, however, the buyer also gives additional incentive for the seller to produce a quality product within the time frame and budget target that the buyer requires.  In this first subtype called the Cost Plus Fixed-Fee or CPFF contract, there is a fixed fee added to the costs IF the seller completes the work as specified by the buyer.  Normally, this is not vary depending on performance criteria (like in the Cost Plus Award Fee contract mentioned below), but is given simply if the work is completed.  The fixed fee is usually some percentage of the initial estimated project costs.  If the scope remains the same, and the project costs on the part of the seller increase, then the seller will still get the production costs covered, but the fixed fee will still be calculated as a percentage of the INITIAL estimated project costs, and so will decrease percentage-wise as the project costs increase.

Of course, if the project scope changes, then the fixed fee will be calculated as a percentage of the NEW estimate of the project costs based on the increased scope of the project.

3.  Cost Plus Incentive Fee (CPIF)

In this type of cost-reimbursable contract, the seller gets reimbursed for all allowable costs (as usual with this type of contract), but then there is an incentive fee which is awarded IF the seller meets certain performance criteria, for example, getting the product completed by a certain deadline.  There is another mechanism of control in this type of contract, and that is the fact that if the final costs differ from the initial estimated project costs, then the overage (or the difference between the final costs and the initial estimated project costs) is split between the buyer and seller according to a cost-sharing formula that is negotiated and agreed upon in the contract.  For example, let’s say that the initial estimated project costs are $50,000, and the cost-sharing formula is 80/20, with the buyer’s percentage typically being stated first and the seller’s percentage typically being stated last.  Let’s also say that there is a $10,000 incentive fee for the seller IF the product is completed by a certain deadline.

How much will the seller be paid by the buyer if a) the product is completed by the deadline, and b) the final costs are $70,000?  The initial estimated project costs of $50,000 would be paid to the seller.  In addition, the seller would receive $10,000 as an incentive fee for completing the project by the deadline.  So far the seller would receive $50,000 (for the initial estimated project costs) plus $10,000 as an incentive fee, or $60,000.  However, since the seller’s final costs were $70,000, which is $20,000 OVER the initial estimated project costs of $50,000, a certain portion of that $20,000 is going to be borne by the seller.  How much?  Well, that’s where the cost-sharing formula comes in.  Since the cost-sharing formula is 80/20, that means the seller’s percentage is going to be 20% of whatever the overage is, in this case, 20% X $20,000 = $4,000.  So that $4,000 cost is borne by the seller, and 80% X $20,000 = $16,000 is paid by the buyer.  So the buyer pays the seller the following:

  • $50,000 (initial estimated project costs) +
  • $10,000 (incentive fee for on-time completion of project) +
  • $16,000 (80% of $20,000 overage paid by the buyer) –
  • $4,000 (20% of $20,000 overage paid by the seller)

which comes out to $72,000, which is like being paid for the $70,000 worth of final costs, with  only $2,000 extra for completing the project on time, because a portion of the incentive fee was eaten up by a portion of the overage costs that the seller had to absorb.  PMI loves to ask questions about this type of contract subtype on the PMP exam, by the way.

4.  Cost Plus Award Fee (CPAF)

In this type of cost-reimbursable contract, besides being paid for the usual legitimate or allowable costs, there is an award given to the seller based on performance criteria.  It differs from the cost plus fixed fee or CPFF contract in that the CPFF contract pays a fixed fee on the basis of whether the seller completes the project.  The CPAF, on the other hand, requires that the seller complete the project AND achieve certain agreed-upon performance criteria (like getting the product completed by a deadline).  The performance criteria requirement makes it somewhat like the cost plus incentive or CPIF contract, which also takes performance criteria into account, but it differs from the CPIF contract in that CPAF contract gives an award that is a fixed amount, not a incentive that can increase or decrease depending on the final costs of the project.

5.  Conclusion

In all three cases, however, the idea behind the fixed fee (CPFF), the incentive fee (CPIF), or the award fee (CPAF) is the same:  it gives additional incentive for the seller to complete the project not only within the initial estimated project amount, but also to complete it within the other major constraints specified by the buyer, either in terms of a deadline or other performance criteria set forth by the buyer.

However, even in the case of a contract where there is a fixed fee or award, the amount can change IF the scope of the project is required by the buyer, necessitating more work on the part of the seller.

The last type of contract, Time & Material (T&M), only has one type, and that is payment per unit of resources supplied by the seller, so there is no need to expand further on that third category of procurement contracts.

The next post will go into detail on the first tool & technique of the 12.1 Plan Procurement Management process, that of the Make-or-Buy Analysis.


One Response

  1. Hi there, thank you for great info. just one small comment on your example for Cost Plus Incentive Fee (CPIF): I think the correct answer is $ 76,000. (Contract cost=70000+10000-4000=76000)

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