Question:

Explain how the following contract types allocate risk between a client and a contractor in

decentralized projects, and assess the merits and limitations of each: - Fixed-price contract -

Cost-plus contract - Performance-based contract - Incentive Contract

Answer:

1- Fixed-Price Contract

Firm-fixed-price contracts provide a price that cannot be adjusted based on the contractor's

experience with cost. Contracts of this nature entail maximum risk and full responsibility on the

part of the contractor for all costs. The contractor is best rewarded for controlling costs and

performing effectively under this contract, and the contracting parties are least burdened with

administrative duties. When an award fee or incentive is solely based on factors other than cost,

the contracting officer may use a firm-fixed-price contract in conjunction with an award fee

incentive. When these incentives are used, the contract type remains firm-fixed-price. Firm-

fixed-price contracts can be used for the acquisition of commercial items or for the acquisition of

supplies or services based on very specific functional or detailed specifications, if the contracting

officer can establish fair and reasonable prices from the beginning, such as:

1. There is an adequate level of price competition.

2. It is possible to compare the price of the same or similar supplies or services with those

obtained previously on a competitive basis or by using valid certified cost or pricing data.

3. It is possible to estimate the probable costs of performance based on available

information about costs or pricing.

 4. It is possible to identify performance uncertainties, estimate their impact on costs, and

estimate the contractor's willingness to accept a firm fixed price reflecting assumption of

those risks.

With an economic price adjustment, a fixed-price contract can be used if: a lengthy period of

contract performance raises serious doubts regarding the stability of labor conditions and the

market. It is possible to identify and deal with separately any contingencies not included in the

contract price. The adjustment of prices based on established prices should normally be limited

to industry-wide contingencies. The contractor should be allowed to adjust the cost of labor and

materials in the event of contingencies. Economic price adjustments are allowed in sealed bid

contracts. A contracting officer should make certain that contingency allowances are not

duplicated in both the base price and the adjustment requested by the contractor under economic

price adjustment clause when establishing the base price from which a price adjustment can be

made. If the contracting officer does not require certified cost or pricing information to be

submitted, he or she should obtain adequate data to establish a reasonable base from which to

adjust the contract price and can require the data to be verified.

Limitations

A fixed-price contract with economic price adjustment shall not be used unless the contracting

officer decides that both it is necessary for the contractor and government to be protected against

significant changes in labor or material costs or to ensure that price adjustments will be made

should the contractor's established prices change.

 2- Cost-Plus Contract

Cost-plus contracts are those in which the contractor gets paid for all project expenses plus an

additional fee. It serves as the contractor's margin. This type of contract is also called cost-

reimbursement contracts and is in contrast to fixed-price contracts, where the contractor receives

a single set fee, regardless of the project's total expenses. Customers may end up paying more for

increased costs under cost-plus contracts, as they transfer some of the risk from contractors to

them.

1. Cost-plus allows contractors to separate profits from the direct and indirect costs

associated with a project. Customers, however, lack certainty regarding the final bill.

2. If project costs increase, contract variations could stipulate fee increases if work is

completed ahead of schedule or exceeds original specifications.

3. A price-plus contract requires careful accounting and tracking of costs, and customers

may ask for a cap on costs.

Merits of Cost-plus Contracts

Following are the merits or advantages of the cost-plus contracts:

1. Having to absorb unanticipated costs due to price inflation is less risky for contractors.

2. Project goals can be met with best-quality materials.

3. Instead of cutting costs, emphasizes meeting performance goals and quality work.

4. The buyer and the contractor are both responsible for managing costs equally.
 Limitations of Cost-plus Contracts

Following are the limitations or demerits of the cost-plus contracts:

1. There is no fixed cost for the project.

2. Buyers are at risk of cost escalation without regular monitoring.

3. Manages and tracks all costs related to the project more efficiently.

3- Performance-based Contracts

Contracts that contain quantitative or qualitative metrics for evaluating a provider's performance

based on the output or outcome they are expected to deliver are known as performance-based

contracts. Improved test scores, improvements in abilities, improved water quality, and reduced

reliance on future services are some examples of performance measures. Standard performance

criteria include providing a target number of clients to be served, completing a specific number

of activities in a timely manner, reducing child abuse and neglect reports within the population,

and improving client function or ability by 10%. Following are the limitations of performance-

based contracts:

1. A performance-based contract's biggest problem is that KPIs are completely out of the

contractor's control.

2. The expectations of the customers are not in specifications. Therefore, the contractors are

suffered from the unacceptable scoring.

 3. Cleaning contractors have a KPI for quality inspections that must be conducted separately

by their customers and themselves.

4. Too many KPIs can be the trap that new customers fall into, typically if they are not used

to measuring service.

5. The performance of services is not measured by all KPIs. For example, some KPIs

measure invoice accuracy and timeliness.

4- Incentive Contracts

It is a sub-section of a fixed-price or cost-reimbursement contract assigned when a specific

budget or timeline is required for a project. For example, a standard incentive contract will allow

you to receive a fixed price if you finish your work by a fixed deadline and at a set cost. An

incentive is offered to a contractor if he can complete a project faster, cheaper, or both.

Depending on the amount of time saved or the amount of costs saved, some incentive contracts

may offer a sliding scale of guaranteed incentives. In addition, some contracts can provide

specific benefits if specific requirements are met within the contract. Following are the merits of

incentive contracts:
1. Work is completed with a greater sense of ownership.

2. It encourages innovation.

3. Throughout the project, better communication is promoted.

4. Personnel assignments are based on skills.

5. Project management can be better overseen.

6. It encourages a higher level of discipline.

7. Positive and negative incentives can be included.

8. Non-monetary rewards may be offered as an incentive.

Following are the limitations of incentive contracts:

1. It increases ownership costs.

2. Negotiations take longer.

3. The priority of the contract can be changed.

4. Chances of dispute increases due to high level of risk.

5. No provision for a one-size-fits-all solution

6. Difficulty in determining the fair incentive targets.