What is a Contract and Define Contract Types with Examples

What is a Contract?

A contract is a mutually binding agreement that obligates the Seller to provide the specified products, services, or results; and obligates the Buyer to pay the Seller for the said products, services, or results.  It represents a legal relationship that is subject to remedy in the courts.

Contract Types

Contract Types are basically two: Fixed-Price and Cost-Reimbursable. There is a third hybrid type called the Time & Materials contract

Fixed Price (FP) Contracts

FP contracts set a Fixed Total Price for a defined product, service, or result to be provided.  FP contracts are used when the Requirements are well defined and no significant Changes to the Scope are expected

Fixed Price Contract Types
What is a Contract and Define Contract Types with Examples
What is a Contract and Define Contract Types with Examples
  1. Firm Fixed Price (FFP)

It is the most basic and commonly used contract. Aka the Lump Sum contract.  The Fee (Contract Cost) is fixed.  Entire Risk is on seller.  Any cost increase due to bad performance of the Seller is the responsibility of the Seller, who is contractually bound to complete the job within the agreed amount

  • FFP is mostly used in government or semi-government contracts where the scope of work is specified with every possible detail outlined.
  • Any deviation from the original Scope can cost the Buyer heavily

Example: The Seller will complete and handover the bridge to NHA for Rs 2.1 billion in 3 years from the signing of the contract

  1. Fixed Price Incentive Fee (FPIF)

In FPIF, although the price is fixed, the Seller is given an additional incentive based on his performance. However, should the Seller delay the project, he is likely to pay Liquidated Damages at the same rate

Example: The Buyer shall pay the Seller 1% of the contract cost for everyone complete month the bridge is completed and handed over earlier.  The Seller shall pay the Buyer 1% of the contract cost as Liquidated Damages for every one complete month the bridge is completed and handed over late (early/late completion of the Project will help/constrain the Buyer start earning revenues from the bridge –tolls, for example -that much earlier/late)

  1. Fixed Price with Economic Price Adjustments (FPEPA)

Used when a project is multi-year long.  It protects the Seller against any adverse economic changes like inflation, cost changes in essential commodities, exchange rate (if the payments are in foreign currency), etc. by adjusting the project cost

Example:  Two years after the project start date, the cost due to the Seller shall be increased by up to 3% based on the Consumer Price Index (CPI)

The major components in an agreement are:
  • Procurement statement of work or major deliverables
  • Schedule, milestones, or date by which a schedule is required
  • Performance reporting
  • Pricing and payment terms
  • Inspection, quality, and acceptance criteria
  • Warranty and future product support
  • Incentives and penalties
  • Insurance and performance bonds
  • Subordinate subcontractor approvals
  • General terms and conditions
  • Change request handling
  • Termination clause and alternative dispute resolution mechanisms
Example of a Common Project

Different types of contracts coming up below would be best understood by considering a common project in all their examples, for example:

Project:  A bridge of certain specifications

Estimated Project Cost:     Rs 1.5 billion

Estimated Project Duration:             3 years

Customer:             National Highway Authority (to be referred to as the Buyer in all examples

Project Contractor:             Izhar Builders (to be referred to as the Seller in all examples)

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