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COST PLUS INCENTIVE FEE CALCULATIONS FOR PMP EXAM

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By Vinai Prakash
One of my PMChamp PMP Coaching Workshop students, Locksley
asked me an interesting question regarding contract calculations. Most
questions in the PMP exam from the Procurement Management
Knowledge Area are about the different types of contracts, and
choosing the best type of contract in a particular situation. But this
one was different
This interesting Contract Question was however about calculations,
requiring you to work out the total payment due to the Contractor
(Seller), in Cost Plus or Fixed Price type of contracts.
In this post, Ill show you how to tackle this kind of contract
calculation questions for the PMP exam.
First of all, you must know what is a CPIF contract a Cost Plus
Incentive Fee contract. In the CPIF contract, the buyer contracts the
seller to reimburse all the costs for the project.
But then, how does the seller make money?
Because only the Actual Cost is covered So the Buyer agrees to pay
an Incentive Fees to the Seller. Thus the name of the contract CPIF.
However, the seller should not take undue advantage of this situation,
knowing that all costs are covered (like having a blank cheque ).
Because the seller can become complacent, knowing that all costs are
covered, and that a profit (incentive) is guaranteed.
Therefore, the Buyer sets out clear guidelines for the incentives, and a
profit sharing ratio. There is a good chance of making a decent profit,
and there is a penalty to finish the project later, or at a higher cost
than targeted.
This incentives the Seller to:
Keep the costs as low as possible,
Finish the contract as early as possible,
And generate the maximum incentive and pr ofit.
Question: A cost-plus-incentive-fee contract has the following
characteristics:
Sharing ratio: 80/20
Target cost: $100,000
Target fee: $12,000
Maximum fee: $14,000
Minimum fee: $9,000
How much will the seller be reimbursed if the cost of performing the
work is $95,000?
A) $98,000 B) $100,000 C) $108,000 D) $114,000
Before we attempt this question, we need to understand the terms set
in this question.
Sharing Ratio
A CPIF contract has a Sharing Ratio. A 80/20 sharing ratio means
that 80% is for the buyer, and 20% is for the seller. Remember this.
The ratio is always written in the Buyer:Seller Ratio format.
Target Cost
The expected cost, or the target cost of this project.
Target Fee
This is the expected fees that the seller will get. The seller is primarily
working to get this fee in doing the project. Plus there is the
expectation of an incentive fee
Maximum Fee
This is the maximum incentive the Seller can expect to get, based on
good performance, and the sharing ratio.
Minimum Fee
This is the minimum incentive fees the seller will get for meeting the
requirements set in the contract.
Calculating the Final Incentive Fee
The final incentive fee due to the seller is calculated as:
Final Fee = ((Target cost Actual Cost) * Sellers sharing ratio) +
Target fee
Substituting the values in the above formula, we get
Final Incentive Fee = (( $100,000 $95,000) * 20% ) + $12,000
= $5,000 * 20% + $12,000
= $1,000 + $12,000
= $13,000
But this is just the incentive. The Seller will also get the costs paid.
Therefore, the Final Reimbursed Price = Actual cost + Final Incentive
Fee
=$95,000 + $13,000
= $108,000
Therefore, the answer for this PMP question would be Choice C =
$108,000.
Another variation of this questions is given below:
Question: Using the same data as above, what will be the
reimbursement to the seller if
the cost of performing the work is $120,000?
A) $112,000 B) $119,000 C) $126,000 D) $129,000
Calculating the Final Incentive Fee
Do note here that the Actual cost is $120,000, and it is ABOVE the
Target Cost. Thus, the seller has exceeded the costs, and will be
penalized.
The final incentive fee due to the seller is calculated as:
Final Fee = ((Target cost Actual Cost) * Sellers sharing ratio) +
Target fee
Substituting the values in the above formula, we get
Final Incentive Fee = (( $100,000 $120,000) * 20% ) + $12,000
= -$20,000 * 20% + $12,000
= -$4,000 + $12,000
= $8,000
This incentive is lower than the Minimum Fee . Thus, the $8,000 will be
adjusted upwards to $9,000 (the minimum amount). The Seller will
also get the costs paid.
Therefore, the Final Reimbursed Price = Actual cost + Final Incentive
Fee
=$120,000 + $9,000
= $129,000
Therefore, the answer for this PMP question would be Choice D =
$129,000.
EXAM TIP: Remember to adjust the Incentive to factor the Minimum
Fee and the Maximum Fees. This is precisely set in the first place,
within the CPIF contract, so that the seller does not make an unduly
high profit. But is incentivised to make the most of it too!
Let me know if this makes sense. Do post a comment, and share your
thoughts.
- See more at: http://www.pmchamp.com/cost-plus-incentive-fee-
calculations-for-pmp-exam/#sthash.KAc0C0QA.dpuf

POINT OF TOTAL ASSUMPTION


CALCULATIONS ON PMP EXAM



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Some time back, we covered the Cost Plus Incentive Fee Type of Contract
Calculations, which is a must know for the PMP exam.
Also watch the video on How to Answer Contract Type Questions for PMP exam.
In the recent past, there have been many questions coming from a relatively unknown
term Point of Total Assumption (PTA) on the PMP Exam.
Surprisingly, the Point of Total Assumption does not even appear in the PMBOK
Guide, Fifth Edition. Yet, questions using the Fixed Price Incentive Fee (FPIF)
contract type often refer to this term.
To understand the PTA, you must first have a good understanding of the Fixed Price
Incentive Fee Contract. In this contract, the buyer agrees to pay a fixed price, and a
maximum price for cost overruns. This is called the Most Pessimistic View of Costs.
Beyond this point, if the cost rises, it will most likely be because of mis-management
at the Sellers end, thus, the seller has to bear all the extra costs beyond this point.
If, however, the seller finishes work at lower cost, there is an incentive, and this
maximizes the Sellers gains.
Lets take an example:
Target Cost: 1,000,000
Target Profit for Seller: 100,000
Target Price: 1,100,000 (Target Cost + Profit for Seller)
Ceiling Price: 1,300,000 ( the maximum the buyer will pay)
Share Ratio: 80% buyer20% seller for over-runs, 50%50% for under-runs.
PTA = ((1,300,000 1,100,000)/ 0.80) + 1,000,000 = 1,250,000.
Beyond the Point of Total Assumption, the sellers profitability decreases, and their
initiative and interest to complete the project may diminish too. Therefore, the PTA is
also a risk trigger. As this point is reached, the project risk increases, and more
attention is needed to complete the project at the earliest, with as little cost deviation
as possible.
In a real project, the Budget at Completion (BAC) should be controlled as closely as
possible, and it is best to keep it under the PTA.
This Point of Total Assumption does not come up in a Cost Reimbursable Contract,
because in a Cost Plus type of contract, the buyer agrees to pay off all the
It is very important that you understand this concept of the PTA for the PMP exam, as
it has appeared for many, although it did not appear in my PMP exam but that was
years ago
All the Best!
Cheers,
Vinai Prakash
- See more at: http://www.pmchamp.com/point-of-total-assumption-calculations-on-pmp-exam/#sthash.tlMJ38sJ.dpuf

Point of total assumption


From Wikipedia, the free encyclopedia
This article is about PTA parameter of Fixed Price Incentive Fee Contracts (project
management). For Fixed Price Incentive Fee contracts, see Fixed Price Incentive Fee
Contract.
This article needs more links to other articles to help integrate it into the
encyclopedia. Please help improve this articleby adding links that are relevant to the
context within the existing text. (November 2012)
Calculation of Point of Total assumption (the case when BAC exceeds PTA that should be treated as a risk trigger, is shown)

The point of total assumption (PTA) is a point on the cost line of the Profit-cost curve
determined by the contract elements associated with a fixed price plus incentive-Firm
Target(FPI)contract above which the seller effectively bears all the costs of a cost
overrun. The seller bears all of the cost risk at PTA and beyond, due to a dollar for dollar
decrease in profit beyond the costs at the PTA. In addition, once the costs on an FPI
contract reach PTA, the maximum amount the buyer will pay is the ceiling price. Note,
however, that between the cost at PTA and when the cost equals the ceiling price, the
seller is still in a profitable position; only after costs exceed the ceiling price is the seller in
a loss position.

Contents

[hide]

1 Calculation of Point of Total Assumption


2 Related terms
3 History
o 3.1 Regulations
4 References

Calculation of Point of Total Assumption[edit]


Any FPI contract specifies a target cost, a target profit, a target price, a ceiling price, and
one or more share ratios. The PTA is the difference between the ceiling and target
prices, divided by the buyer's portion of the share ratio for that price range, plus the target
cost.
PTA = ((Ceiling Price - Target Price)/buyer's Share Ratio) + Target Cost
For example, assume:
Target Cost: 2,000,000
Target Profit: 200,000
Target Price: 2,200,000
Ceiling Price: 2,450,000
Share Ratio: 80% buyer20% seller for overruns, 50%50% for underruns

PTA = ((2,450,000 - 2,200,000)/ 0.80) + 2,000,000 = 2,312,500.


If for a moment, PTA is given and you are trying to calculate the ceiling price for the
buyer (maximum amount that the buyer will have to spend),the calculation will be
(2,000,000 (target cost) + 200,000 (the profit the buyer pays to the seller) + (2,312,500 -
2,000,000)*0.8 = 2450000.
This is a term used in project management when managing specific fixed price contracts.
The reason to calculate PTA is that when executing the contract, actual cost is the only
finance measurement. Compare this measurement with the cost base line to calculate
Cost Performance Index (CPI), then we can estimate the Budget at Completion (BAC). If
BAC exceeds PTA, the buyer is expected to pay the ceiling price, and any more overruns
beyond PTA will cause a dollar for dollar decrease in profit for the seller. The profit
decrease rate become higher, and once actual cost exceeds ceiling price the seller will
start losing money(and then might stop working for the contract). For the risk
management point of view, BAC should be controlled under PTA to keep this risk far
away. When "BAC exceeds PTA" is found in control cost process, it should be treated as
a risk trigger.

Related terms[edit]
For cost reimbursable contract, the Point of Total Assumption does not exist, since the
buyer agrees to cover all costs. However, a similar incentive arrangement with similar
components, called a Cost-Plus-Incentive Fee (CPIF) contract sometimes is used. The
CPIF includes both a minimum fee and a maximum fee. The share line in combination
with the Target Fee, Maximum Fee and Minimum Fee can be used to easily calculate the
points at which the incentive arrangement affects fee. The range between these points is
called the "range of incentive effectiveness."

History[edit]
The idea of a "Point of Total Assumption" is an extremely recent one. In the government's
efforts to cut cost overruns, the PTA is being introduced to FPIF contracts on an
increasingly wide basis. Moreover, high-level professional examinations for industry
certification, such as the Project Management Professional certification, are beginning to
test applicants' knowledge of this concept and its application.
Regulations[edit]
For contracts subject to the Federal Acquisition Regulations, FAR 16.403-1 provides the
Government description of FPI. The contract type is implemented by calling out FAR
Clause 52.216-16 Incentive Price Revision - Firm Target. This clause captures
the Ceiling Price as well as the government share ratio(s). If multiple line items are
identified as FPI type, the individual line item information shall be included here,
otherwise final contract costs and price are reconciled at the contract level.

References[edit]
Langford, John W. (2007). Logistics: principles and applications. SOLE Press Series (2nd
ed.). McGraw-Hill. pp. 207208. ISBN 0-07-147224-X.