Types of Fixed Price Contracts: Everything You Need to Know
A fixed price contract is a legal agreement between two or more parties to provide a defined product or service at an agreed upon price.3 min read
There are different types of fixed priced contracts. A fixed price contract is a legal agreement between two or more parties to provide a defined product or service at an agreed upon price.
What Is a Fixed-Price Contract?
Fixed-price contracts may include provisions for flexibility of price adjustments based on environmental factors, such as inflation. In addition, when time is of the essence, the contract may provide an incentive for early completion. It can also include a penalty for costly delays.
When routine product supply and services are repeatedly sold or performed, this presents the ideal condition for fixed-price contracts. In view of the fact that the seller absorbs most of the risk, a familiarity with all details involved in how the company carries out the supply and demand process should be considered.
After the price and terms of the contract have been agreed upon, the responsibility to meet the needs of the project lies solely with the seller. As fixed-price implies, the buyer pays the agreed upon fixed price once all terms of the contract have been met.
As previously mentioned, financial incentive clauses are often included to motivate cost reduction behaviors, such as meeting deadlines or other measurable objectives. In addition, award fees can be set aside to encourage parties to perform above the agreed terms.
How to Create Fixed-Price Contracts
While fixed-price contracts can be profitable, failing to compute and consider all costs involved can cause a considerable loss for a company.
Here is a look at key factors for pricing decisions and strategies:
Research and know all the costs involved in meeting the request. This includes labor, materials, and expertise that will need to be acquired.
While a conservative approach will help offset the risk level, it is better to have a pricing strategy in place that meets your business goals. This will also help prevent poor pricing decisions, like overpricing and underpricing.
A work breakdown structure (WBS) should be the first step in computing a fixed price for a project. The use of WBS provides an estimate for each phase and category of the project, such as labor hours.
To get the proposed contract cost for labor, be sure to include the standard labor rate, plus material, travel and any other costs involved.
In addition, your general and administrative expenses should be considered and computed in the project cost.
Absorbing the majority of the risk should be factored in by adding an additional fee as a cushion for unseen expenses and mistakes. If a seller feels confident in meeting the demands with little difficulty and wants to provide a more competitive rate, this fee may be reduced.
What Are the Types of Fixed-Priced Contracts?
- FFP – Firm Fixed Price: A commonly used contract used in commercial products and servicing when the market is competitive. This type of contract is not subject to any adjustment in cost and places all the risk on the contractor.
- FP/EPA – Fixed Price with Economic Price Adjustment: This contract allows for market fluctuations as the government absorbs part of the risk.
- FPI – Fixed Price Incentive: When a fixed price incentive is entered, the government shares part of the risk by setting a maximum amount to pay and then the contractor assumes all risk above the set cost.
A formula based on the total cost, the projected cost, and ending profit are used in the FPI contract to allow adjustments of profit and final cost. Using the formula, the final cost is computed and agreed upon after all the work is completed.
The formula can take into account other objectives, such as performance and cost reductions when agreeing on a final cost. There will need to be a calculable dollar amount established when computing performance and evaluation cost to establish a final cost.
In a competitive environment, price alone is not always enough to ensure a client stays committed to allowing you to meet their supply and demand needs. Additional incentives or provisions are often necessary. An effective pricing strategy for your business has important implications in your attempt to attract clients and achieve favorable profit margins.
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