Agile Contract Types–Part 1

An agile contract is one that is designed for an agile project management environment.   In my last post, I discussed properties that all agile contracts share.   In this post, I do a recap of traditional project management contracts in order to give a context for how agile contracts differ.

Here are the elements of the Agile Manifesto as created in 2001 by the Agile Alliance:

  • Individuals and interactions over processes and tools
  • Working software over comprehensive documentation
  • Customer collaboration over contract negotiation
  • Responding to change over following a plan

Note that the word “over” appears in every element of the manifesto.   The one relevant to agile contracts, of course, is element #3, “customer collaboration over contract negotiation.”   This means that contract negotiation is necessary, but that the priority needs to be placed on customer collaboration.   Why?   The creation of a contract in and of itself does not add value from an agile standpoint; the value is created in the customer collaboration and the contract is a mere formalization of this collaboration.

The agile contract acts as a type of risk management response.   What happens if things do not go as smoothly as the customer and the company doing the project envision at the beginning?   In a way, by making sure that there are contingencies for those possible future events (i.e., the risks), you can make sure that the team is spending all of its energy on creating value for the customer in the present moment.

Before I discuss the three types of agile contracts, let me review the three types of contracts used in the traditional project management environment.

Three Types of Contracts in Traditional PM

The three types of contracts in traditional project management are:

  1. Fixed price
  2. Time & material
  3. Cost reimbursable

Fixed Price Contracts in Traditional PM

These three differ with regards to how they answer the question:   who bears the greater share of the cost risk?    Let me explain first what the cost risk is before we explore this question.   The seller creates a product for the seller.   The amount of money it costs the seller to create the product is the “cost”, and the seller adds to the cost the amount of profit the seller wants to make, called the “fee”.   The “cost” and the “fee” together make what the buyer will pay the seller, namely, the “price” of the product.   In a fixed-price contract, if the “actual cost” of the product is higher than the “target cost”, the seller will pay the “target price” no matter what.   This means that, as the actual cost goes up, it eats into the fee or profit margin of the seller, and if it goes too high, i.e., higher than the target price, then the seller will actually lose money.   This is why the fixed-price contracts favors the buyer in terms of cost risk.

Cost-Reimbursable Contracts in Traditional PM

Let’s skip to the third type, cost reimbursable.   In this case, the buyer guarantees to pay the target price, no matter what the target cost is.   This is obviously favoring the seller rather than the buyer in terms of cost risk.   There are ways to balance the cost risk by using devices such as a “ceiling price” or a “cost incentive fee”, which I won’t go into here.   But traditional project management acknowledges that the cost risk favors one side or the other, and adjustments can be made to the basic two contracts type of “fixed price” and “cost reimbursable” to address that imbalance.

Time & Material Contracts in Traditional PM

The second type of contract has a cost risk which in some ways favors the buyer and in some ways favors the seller, and that’s why I put it in between the other types which clearly favor one side or the other.   When I was working for a Japanese manufacturer doing litigation management, our company would hire lawyers to help defend the company in the case of a lawsuit.   They were paid on a per-hour basis, with the fee depending on the experience of the attorney.

This is a typical example of a time & material contract.   We paid for the services of a person who worked for us on a per-hour basis.   How does such a contract favor the buyer (our company)?   The fee structure would not change during the duration of the case, so there was an element of predictability about it.   On the other hand, the fact that the number of hours worked by the lawyer was not fixed favored the seller (the law firm the lawyer belonged to).

So in terms of cost risk, you can list the three types of contracts in the following way, where a higher cost risk to the seller is to the left, and a higher cost risk to the buyer is to the right.

Fixed Price –> Time & Material –> Cost Reimbursable

In agile contracts, on the other hand, all three types try to balance the cost risk between seller and buyer, and the difference comes to not how they are structured in terms of cost, but how they are structured in terms of time.

With that background regarding the three types of contracts in traditional project management, let us turn in the next post to the three types of contracts in agile project management.


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