Contract Management

The first thing we need is a definition of a contract. Texts on business law define a contract as follows:

A contract is an agreement between competent parties, for consideration, to accomplish some lawful purpose with the terms clearly set forth.

First of all, the contract is an ''agreement.'' This means that the parties involved must have a meeting of the minds and decide that they will do the things set forth in the contract. By this definition no contract can be forced on someone. If there is any kind of forcing or coercion, there cannot be an enforceable contract. You cannot force someone at gunpoint to sign a contract to buy aluminum storm windows and expect to hold the person to the contract.

The contract must be ''between competent parties.'' This means that the people who make the agreement must be competent to make the agreement. Persons who are impaired in any way that makes them unable to make responsible decisions or people who are not of age cannot make contracts. As a matter of fact, if a minor or another incompetent party enters into a contract, the contract may be enforceable on the competent party and not on the incompetent party.

The contract must be ''for consideration.'' This means that something must be given for something else. If there is no exchange of anything, then there is no contract. There would be no point in going to the trouble to create a contract if there is no exchange. It is important to note that the consideration does not have to be something that is valuable to everyone. The consideration could easily be something that one person values and no one else does. The consideration does not need to be tangible either. An intangible consideration can be involved in any contract.

The contract must ''accomplish some lawful purpose.'' No contract can legally be written that violates the law. You cannot contract with someone to steal a car for you. The contract would be void at its inception.

In discussing contract management for projects we generally are interested in the relationship between a buyer and a supplier.

Make or Buy

The decision to make or buy something must be considered. Many times it is less expensive to purchase something from an outside source than it is to make the item inside the company. Cost is a major consideration for this, but there are many other reasons for deciding whether to purchase or make an item. If a facility has idle capacity, it may make sense to produce a part that is normally made by an outside vendor. The excess capacity is there to be used, and the company is paying for it whether it is used or not. In a make-or-buy decision, it should be necessary to consider only the variable cost in this situation. If there is no extra capacity, then the cost of adding the capacity must be considered as well.

If an item is needed and it is important that strict control be maintained in its production, it may be necessary to make the item instead of purchasing it. Similarly, items that involve trade secrets and innovative products should not be contracted out of the company.

Using the flexibility of the purchasing system to stabilize the workforce is desirable. Many companies have used this strategy to help maintain consistent employment levels in their companies. A company wishing to do this subcontracts some of the work to outside companies. When the demand for its product goes down, the company decreases the amount of work that the outside contractor is doing and maintains the constant level of work in its own facility. It does not take vendors long to figure this out and adjust pricing for the product to compensate them for their own stability problems.

The decision to purchase an item may simply be a matter of a company not having the ability to produce the item. Skills may be unique for this project and may not be needed in the future. Buying equipment to produce items that will be needed only for this project may not be justifiable, and it may be less costly to buy the items in question or to lease the equipment to produce them.

Contract Life Cycle

The contract life cycle must be managed like the project life cycle. The contracting process is very similar to the project management processes of initialization, planning, implementation, and closeout.

In the contracting process, we consider the steps in a little more detail (Figure 8-1). The requirement stage of the contracting process can be considered equivalent to the initialization of the project. The requisition, solicitation, and award stages can be considered equivalent to the planning process. The contract can be considered equivalent to the implementation process. Closeout occurs at the close of the contract.

Figure 8-1. Contracting process life cycle.

Requirement

Requisition

Requisition

Solicitation

Solicitation

Award

Award

Contract

Requirement Process

In the requirement process the needs of the project are identified. As in the requirements definition of the project, the requirements of the contract are identified. These requirements come from a needs assessment, and the needs are further reduced to requirements. Before the decision to purchase a good or service is made, a decision must be made as to whether the item should be purchased or made internally. Requirements are frequently stated in a document called the statement of work.

Cost estimates must be produced to help predict what the correct cost of the item should be. These cost estimates help the person doing the purchasing to determine whether the potential vendor is quoting a fair and agreeable price.

As in the project management requirements definition, the process begins with a determination of needs. These are the items that someone wishes to have delivered. These needs are reduced by mutual agreement to requirements. The requirements are further reduced by excluding the requirements that are not justified.

Requisition Process

The requisition process consists of reviewing the specifications and statement of work and identifying qualified suppliers. It is sometimes called solicitation planning.

During the requisition process, the requirements definition is passed to the purchasing personnel. These may or may not be part of the project team. The specifications and statement of work are reviewed, but now there is input from the purchasing function. This input provides cost information that may further reduce the requirement of items that are now deemed to be impractical.

At this time all of the signatures necessary to procure the item are added to the requisition. Certain signatures are required before the company can be committed to make an expenditure, and other signatures are necessary to be sure that all necessary persons are informed about the purchase being made.

Solicitation Process

The solicitation process involves obtaining bids or proposals. During this process a number of vendors are solicited to participate in the process of becoming the chosen vendor. In the case of commodity purchases it may be necessary to evaluate only the price of the item being supplied. In the case of unique items it may be necessary to evaluate many different aspects of the vendor and the product that is proposed. Frequently procurements are advertised in trade news publications to ensure fairness to all vendors. Oftentimes this is a requirement for any government agency's procurement.

There are two major forms of solicitation, the request for proposal (RFP) and the request for quote (RFQ). When the RFQ is used, potential vendors must meet all of the requirements of the RFQ and must deliver exactly what has been asked for. When the RFP is used, vendors are at some liberty to meet the functionality described in the RFP. Because of this flexibility each vendor may propose something different and at a different price.

Using the RFQ process makes the vendor decision very simple. Since all vendors are required to supply exactly what was asked for, the only difference between them is the price. The buyer must be very careful in preparing the bid specifications because the vendor will be required to supply what was asked for.

In the RFP process the specifications are more of a functional nature and do not define what is to be delivered as much as they define the functions that the items delivered are supposed to do. While the major part of the work in the RFQ process comes when the bid specifications are written, the RFP process requires most of the work to be done during the evaluation of the proposals submitted.

As an example of how this works, suppose a city government wanted to purchase 500 laptop computers for the city hall staff. They write up the bid specifications for a Pentium 5 processor, with 60 GB of hard drive space, floppy disk drive, and 15-inch screen. The procurement process at city hall is rather lengthy. By the time the laptop computers are delivered, the state-of-the-art laptops have a Pentium 7 processor, 120 GB hard drive, and no floppy drive at all. Not only that, but to meet the specifications the vendor would have to special order the computers, making the overall cost higher than giving the customer something superior to what was asked for. All of this may result in a forced re-bid, and the process could start over and over again.

Vendor conferences, also known as bidder conferences or pre-bid conferences, are used to allow all of the vendors to come to a meeting where they may ask any questions regarding the bid or proposal. A conference of this type allows potential vendors to ask about anything that is unclear about the procurement, and to hear what is being said to the other vendors so there is no risk of one vendor having information that others do not possess.

Qualified Sellers Lists can be developed by the project team or the procurement department. These lists can be constructed based on publicly available information on the Internet; in libraries, Dun and Bradstreet reports, and the Thomas Register; and from various other sources. Potential vendors may also be sent questionnaires to determine their qualifications and interest in doing business in a particular area.

Award Process

During the awarding process, one vendor is selected from the ones solicited. At this time the contract is written, negotiated, and signed by both parties.

The writing and signing of the contract can be simple, as in the purchase of a commodity. In the purchasing of such common items the contract is generally a standard item that is written on the back of a purchase order. Many times these contracts are written in very light ink and in very small type.

In more complex purchases, the contract may have to be negotiated, and specific terms and conditions for this particular contract must be agreed to. The more detailed the contract, the more complex this part of the contracting cycle will be.

Trade-Off Studies

One of the methods of evaluating potential suppliers is the trade-off study. This is a useful process in that it gives us a consistent way of evaluating the potential suppliers and documents each of the reasons why a particular vendor was selected.

Potential vendors may be eliminated through a screening process. By screening we mean that we establish definite requirements of performance, and any vendor that does not at least meet these minimums is automatically disqualified. For example, a vendor might be required to have a project manager assigned who is a certified PMP.

As can be seen in Figure 8-2, a trade-off study is begun by listing all of the potential vendors across the top of the page in columns. The features or the desirable traits of the object being purchased are written down the first column. Another column is added to show the relative importance of each of the features. This is called the weight column. Each of the vendor columns is divided in two: rank and score.

We begin by listing the features. These are all of the important traits that will be part of the evaluation process. Features that might be included include total life cycle cost, price, technical approach, management approach, ability to perform the work, and understanding of what was asked for. For a complex selection this list could go on for several pages. Next, the weight factor is determined, and each one of the features is evaluated for importance. The number here is one of relative importance. A feature that is given a 6 should be twice as important as a feature given a 3. Next, each potential

Figure 8-2. Trade-off study.

Alt. 1

Alt. 2

Alt. 3

Criteria

Weight

Score

Wt. x Score

Score

Wt. x Score

Score

Wt. x Score

Total Score

vendor is ranked according to their ability to supply this feature. If more than one vendor furnishes this feature equally they can receive the same rank, or a scale of 1 to 10 can be used to evaluate how well each vendor supplies the feature. The rank number for each vendor for each feature is then multiplied by the weight factor of each of the features and written in the score column. Summing the score numbers will produce a high score for one of the vendors. This is the preferred vendor.

The trade-off study seems to be quite analytical and quantitative, but in reality it is not. The choosing of the weight factors is very subjective, as is the assignment of ranking numbers for the potential suppliers. Multiplying them together multiplies the errors as well. The method, however, has one great advantage to justify its use. The orderly arrangement of the selection criteria and the evaluation of each supplier is plain to see, and it shows anyone objecting (probably one of the unselected vendors) to the vendor selection exactly what things were considered.

Contract Process

The contract process is the final part of the contracting process. In this process the contract is actually carried out. The vendor and the purchaser must follow the planning process, organize the work staff for the work to be done, and control the contract. The purchaser and the seller must both be responsible for their part of the contract.

Contract Administration

As contracts become more complicated and more valuable the administration of the contract becomes more and more important. In administering a contract we are the client of the project, and we should expect that the supplier's project manager will be able to furnish us with information regarding the performance of the project team. On large projects, reports from the project manager should include progress reports on scheduling, performance reports on scheduling and cost, quality control reports, risk monitoring and control reports, and change control reports. At times it is desirable that the contract administrator for the buyer visit the facility where the work is taking place and verify that the reports do in fact report what is really going on.

Contract Types

In the world of commerce nearly any kind of agreement can be made that will satisfy the needs of both parties of the contract. Whenever there is a contract, there is always business risk. The business risk is that there can be a positive or negative outcome to the contract, depending on the risks involved and whether they work out favorably or not (see Figure 8-3).

Fixed-Price or Lump-Sum Contract

A fixed-price contract requires that a project be completed for a fixed amount of money. The seller agrees to sell something to the buyer at a price that has been agreed to beforehand. The seller agrees to provide the buyer with something that meets the specifications as agreed, and the buyer agrees to give the seller a fixed amount of money in return. Strictly speaking, in this kind of contract, the seller must do the work specified for the agreed upon amount. In the real world, if problems occur that make it impossible for the seller to perform for the agreed upon price or if the supplier is having severe financial problems, agreements can be modified.

In fixed-price contracting, the seller is taking all of the risk of having things go wrong, but the seller is also setting the price in such a way as to be compensated for

Figure 8-3. Customer and supplier risk.

Low Risk Customer High Risk

Fixed Price Cost Reimbursement

FP + Award

Cost Cost Sharing Cost + FF

Supplier

Low Risk taking the risk. In fact, in this type of contract it may be that the buyer is paying more than would have been necessary if the buyer had been willing to take some of the risk.

In fixed-price contracts there is no need for the buyer to know what the seller is actually spending on the project. Whether the supplier spends more or less should be of no interest to the buyer. The buyer should be interested only in the specifications of the project being met.

There are several variations on the fixed-price contract.

Firm Fixed-Price Contract. In a firm fixed-price contract the seller takes all of the risk. In our discussion on project risk, one of the strategies for handling risk was to deflect or transfer the risk to another organization. The most risk-free way to transfer the risk is to use a firm fixed-price contract. Here the contract terms require that the seller supply the buyer with the agreed-upon goods or services at a firm fixed price. In other words, the supplier must supply the good or service without being able to recover any of the cost of doing the work if cost-increasing risks occur during the fulfillment of the contract.

Frequently, in this type of contract, if the supplier cannot perform for the agreed upon amount, there is some room for negotiating even after the contract has been agreed to and signed. The firm fixed-price contract has the most predictable cost of all of the types of contract.

Fixed-Price Plus Economic-Adjustment Contract. In this type of contract some of the risk is kept by the buyer. All of the risks associated with the contract are borne by the seller except for the condition of changes in the economy. This type of contract can be used when there are periods of very high inflation. The contract price is adjusted according to some formula that depends on an agreed upon economic indicator.

The economic adjustment is important when there are periods of high inflation and the length of the contract is long. During the time of the contract, the value of money may go down considerably and the value of the contract along with it. For example, one company agrees to purchase a project from another company. The time that it will take to complete this project is one year. During the time between the agreement and the delivery of the project, there is high inflation, say 20 percent per year. In our discussion of cost management in Chapter 3, we looked at the effect of present values and saw that money that we receive in the future is worth less than the same money received today. Therefore, it is reasonable that the supplier increase the selling price of the project by 20 percent if the money will be paid at the end of the one-year project.

However, suppose that inflation rates and interest rates are unstable. In this situation the seller does not know how much to increase the price in order to be compensated for the time value of money. Inflation may be 20 percent, or it may be 30 percent. The supplier wants to figure the selling price based on 30 percent, but the buyer argues that the inflation rate could be only 20 percent.

The buyer and supplier agree that they will adjust the selling price up or down according to some economic formula. In this situation it might be reasonable to adjust the selling price at the end of the project according to the average interest rate over the period. In the 1970s many contracts were written with economic adjustments based on the consumer price index. Many other economic indicators can be used for adjusting prices.

Fixed-Price Plus Incentive Contract. In a fixed-price plus incentive contract there is an agreed upon fixed price for the project plus an incentive fee for exceeding the performance of the contract. In this type of contract the buyer wishes to create some incentive for the supplier. The buyer offers to increase the amount to be paid for the completion of the project if the supplier delivers the project early or if the project performance exceeds the agreed upon specifications.

In this situation the risk of meeting the conditions of the project are borne by the supplier, but the buyer assumes some additional risk. The buyer really wants the project to be delivered early or with the enhanced features in the incentive part of the contract but is not able to get the supplier to agree to these terms as part of a fixed-price contract. If the extra enhancements are actually delivered or if the project is completed early, the buyer will pay extra. If the project is completed without the enhancements or is completed in the agreed upon time, the contract terms are met and the incentives are not paid.

For example, the Jones Company wants to buy a new machine. Jones can use the machine as soon as it is delivered to satisfy orders for its product. It contracts with the Ace Machine Company to deliver the new machine. Ace is only willing to promise a delivery of six months because of problems that usually occur in this type of project. If the contract is a fixed-price contract with no incentive fees, the Ace Company will deliver the machine on time. If there is a fixed-price plus incentive contract, the Ace Company may be motivated to deliver early. There may be an incentive of $500 per day for early delivery.

With this type of contract there is usually a penalty for delivering late or for delivering a project that does not meet all of the requirements. The Ace Company may be required to deduct $500 per day for delivering the project late.

Cost-Plus Contract

A major distinction is made between contracts that are fixed price and those that are cost reimbursable. In a cost-reimbursable contract the supplier agrees to perform the terms of the contract, but the buyer takes on the risk. The buyer agrees to reimburse the supplier for any work that is done and for any money that is spent. When the contract is completed, the buyer pays a fixed fee to the supplier for the work that was done. This is essentially the profit for doing the project.

Cost-reimbursable contracts are usual when there is a great deal of risk and uncertainty in the project or a significant amount of investment must be made before the final results of the project can be reached.

For example, the U.S. government wants to develop a new tank for the army. The requirements are not clear, and the design of the tank must be modified to accept the latest state-of-the-art designs for its components as it is being developed. The approval and development process may take as long as ten years. There are probably no companies that would agree to a fixed-price contract for this project, so the government awards a cost-plus contract instead.

In a cost-plus type of contract the buyer is actually taking the responsibility for the risk. If problems develop in the project, the buyer will have to pay for the corrective action that is necessary. Some of the time this can actually be economical. In projects with a lot of risk, the supplier usually will estimate the cost of the risks and charge the buyer enough in the price to adequately compensate for taking the risk. In a cost-reimbursable contract the actual costs of the risks that occur are the only ones that are paid for.

One of the problems in a cost-reimbursable contract is the determination of the actual cost. There is always the danger that the seller's report of the actual cost to the buyer may contain costs of some other project. This means that the buyer needs to check to be sure that misallocation of cost is not occurring. In large federal government projects, staffs of auditors check on correct cost reporting to ensure that this is not a problem. Many times the cost of the auditing and tracking system to ensure correct reporting makes these kinds of contracts difficult to apply unless the projects are large.

Cost Plus Fixed-Fee Contract. In a cost plus fixed-fee contract the seller is reimbursed for all of the money that is spent meeting the contract requirements and is also paid a fixed fee. The fixed fee is essentially the profit for managing the project. Without some sort of fee in addition to the actual cost of the contract there would be no profit, and the company would simply be making the money that it spent. No company would knowingly take on this kind of contract.

In a cost plus fixed-fee contract, the supplier has only a small incentive to control cost and complete the project. Regardless of when the contract is completed and as long as the specifications are met, the supplier will get only the profit from the fixed fee.

All of us have had this kind of contract at one time or another. A good example of what can happen is when I hire my teenage child to mow the lawn. Essentially this is a cost plus fixed-fee contract. I am responsible for the equipment and gasoline and maintaining the lawnmower. The labor is supplied by the teenager for a fixed fee. Generally, the results of this contract are that the lawn will get mowed but may not get mowed soon.

Cost Plus Award-Fee Contract. In a cost plus award-fee contract an award system is set up to compensate the supplier for completing parts of the contract. The award fee can be determined by many different criteria including the quality of the workmanship, the correct filling out of reports, and practically any other criteria that are agreed to. As each of these requirements is met the award fee is determined and given to the supplier.

Cost Plus Incentive-Fee Contract. In a cost plus incentive-fee contract an incentive system is set up for the supplier to perform in excess of the agreed upon terms and specifications of the contract. Similar to a fixed-price plus incentive contract, the cost plus incentive-fee contract allows the supplier to exceed the specifications and requirements of the contract. When the project is delivered early or when the design criteria and specifications have been exceeded, the incentive fee is paid.

The cost plus incentive-fee contract is the least predictable of all types of contract. Not only is the variable cost of the work included in the contract but the variable incentive that must be paid to the seller must also be considered.

Time-and-Material Contract

This type of contract is a mixture of fixed-price and cost-reimbursable contracts. In this type of contract the total cost of the contract may vary considerably depending on the total amount of time and material that is expended. There are, however, some fixed costs associated with it. For example, the total amount of engineering labor may not be specified but the cost of the resource per hour may be part of the contract.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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