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In the last post on the inputs to the Procurement Management Plan, I listed some of the categories of contracts you can have with a vendor who is producing something you need for your project.

For a person who is new to procurement management, the list of categories (Fixed Cost, Cost Reimbursable, Time and Materials) and the subcategories underneath each of these can be hard to keep straight in your mind.   However, it becomes very simple to understand the difference between the main categories of Fixed Cost contracts and Cost Reimbursable contracts if you understand the concept of cost risk.

Now, risk as you is an event or condition which has an impact on the project, either a positive impact (an opportunity) or a negative impact (what people most commonly think of as a “risk”).    If you look at which particular constraint the risk has an impact on, you can get several categories of risk, such as scope risk, schedule risk, and cost risk.  What it means is that the risk in question may have a positive or negative impact on the costs of the project.   In other words, at least for a negative risk, it might cause the project to go over budget.

In the case of a procurement, it means that the cost to the seller of producing the procurement may exceed the cost that the buyer had originally agreed to pay.   Who pays for the overage?   THAT is the key question which determines whether a contract is a Fixed Cost contract or a Cost Reimbursable contract.    In a Fixed-Cost Contract, the buyer agrees to pay a certain cost for the procurement, and if the costs are above that agreed-upon amount, the seller has to pay the additional costs.   That means that the seller has a cost risk.

Now, in a Cost-Reimbursable contract, the buyer agrees to pay the additional costs, which means it is the buyer who has the cost risk.   So in either type of contract, there is a cost risk either on one side of the transaction or the other.   The whole purpose of the subcategories under each type is to create incentives to balance the cost risk between the parties, so that no party feels that it is taking on the burden of the majority of the cost risk.  The type of incentive will determine the type of sub-category of each contract type.

So that is the relationship of the cost risk to the type of procurement contract you choose.   In a future post, I will discuss the different types of incentive.  In the next post, I will return to discussing the first procurement management process, 12.1 Plan Procurement Management.

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