Project managers play an integral role in selecting third party vendors to perform work on projects. It is no realistic, in most cases, to complete projects with only internal resources. Additional skills can be accessed via outsourcing and often provide specialty services that are unavailable otherwise.
While procurement, purchasing, and legal departments normally take the lead in contract negotiations, project managers need to also take an active role in procuring third party materials and services. After all, the project manager will be integrating the work of the vendor or supplier with all other aspects of the project. This includes understanding the scope, schedule, cost, quality, and risk of the third party work.
Contracts are used in projects to outline the legal responsibilities of the seller and the buyer. The seller may be also identified as the vendor, supplier, or third party. The buyer may be identified also as the customer, client, or sponsor.
A contract is a legally binding agreement in which the seller agrees to provide labor, equipment, materials, or other services in exchange for some form of payment. The buyer agrees to pay the seller for the work provided; usually, the payment is made in monetary terms (e.g. $10,000 or 10,000 €). However, in some cases, exchange of valuable goods may be made in lieu of money. For instance, the right to license a process or access to patent-protected technology may be considered a valuable exchange by the buyer and seller in a contract.
It is important to keep in mind that a contract is a legally binding agreement. Normally, the terms and conditions will state the jurisdiction of law under which the contract will be executed. This may be stated as “according to the laws of the State of Texas” or in discussing mediation if the parties later disagreed upon the service rendered or payment received. Thus, third party agreements should not be treated casually.
The Basic Contracts
Project, product, and engineering managers should be familiar with the three most common types of contracts. While there are variations on these types of contracts that add risk or may reduce cost, most project managers can participate in a technical negotiation with a clear understanding of these basics.
Fixed Price Contract
The firm fixed price contract is used when the buyer can explicitly describe the materials, equipment, or services to be acquired. The buyer agrees to a specific price (“fixed”) and the seller agrees to provide the goods and/or services.
A fixed price contract is of little risk to the buyer because there is no room for variation in the price of the goods or service being procured. Of course, project, product, and engineering managers will prefer this type of contract since it allows a firm budget estimate. However, the project manager must be extremely clear in describing the full scope of work in the contract as the seller will be constrained to provide exactly what is stated in the contract.
In a fixed price contract, the seller is at a greater degree of risk than the buyer. Many factors can impact the completion of the work as specified that may add cost to the project work. For instance, an unexpected period of high inflation or a labor shortage that drives up wages can impact the cost of the work that the seller provides. Furthermore, if the seller underestimates the scope of work, they are still legally obligated to provide the agreed-upon work product, even at a financial loss.
Both the buyer and seller will be particularly attentive to changes in a fixed price contract. The seller will view the contract as a minimum standard. Anything that the buyer requests that is not explicitly called for in the contract may be considered a change. Change orders are often expensive and can introduce schedule delays as well. Again, it is important for the buyer to be familiar with the work and to provide a detailed scope statement to avoid eth potential of costly changes later.
Cost Reimbursable Contracts
Cost reimbursable contracts typically involve more risk for the buyer than the seller. In this type of agreement, the seller is reimbursed for all actual costs as they are incurred. Usually, the seller will invoice the customer on a regular basis, say weekly or monthly.
A buyer has more risk with a cost reimbursable contract than in a fixed price contract because the total cost of the work is not predetermined. Sellers may incur more overhead costs using this type of contract since they will spend more time justifying expenses to the customer. Buyers normally protect against financial risk by requiring specific documentation for costs incurred and/or by including a price cap within the contract terms and conditions.
A cost reimbursable contract is useful in situations where the end result in unknown. This might be the case for a research study or if the scope of work is unclear. For example, a home remodel project may involve uncertainties regarding the condition of subfloors, piping, and supports. In other situations, the end product may be ill-defined due to the nature of the work, such as in new product development where customer inputs will guide decisions throughout the project life cycle.
Evaluation of fixed price contracts is easy. Normally, a buyer will choose the lowest bid. Cost reimbursable contracts must be evaluated based upon estimated total costs as well as other factors. These can include approach to the work, experience, past performance on similar projects, and/or technical and management capability. A vendor-customer relationship built on trust will enhance the execution of a cost reimbursable contract.
Time and Materials Contract
Finally, a time and materials contract is a hybrid between a fixed price and cost reimbursable contract. Materials, equipment, and supplies are provided at a fixed (known) price while labor is reimbursed as necessary to complete the project work. An example of a project in which a time and materials contract might be used is in venture software installation. The cost of the software licenses is fixed (e.g. $300 per user) but operating system upgrades, testing, and data transfers are variable. Like a cost reimbursable contract, buyers often include a price cap for a time and materials contract.
Project managers should be involved when contracts are negotiated for third party work. Technical specification and requirements are the responsibility of the project manager during negotiations. Moreover, the project manager has a vested interest in the delivery schedule and cost of outsourced project work because it must be integrated with all other project activities. Third parties also introduce special concerns regarding risk, quality, and communication – areas which are key responsibilities for a product, project, or engineering manager.
Project procurement is one of ten (10) knowledge areas covered on the Project Management Professional (PMP™) exam. If you are planning on becoming certified, you will want to consider a PMP review course and/or practice tests. Candidates who prepare with a PMP training course are more likely to pass the exam on the first try. Join us for online study sessions – contact me at info@Simple-PDH.com or 281-280-8717 for more information on our next available study session.
Contract management is a key responsibility for product, project, and engineering managers. Be on the lookout for a special PDH course on contract management where you can refresh your skills, learn new tools, and earn professional development hours (PDH). At Simple-PDH.com where we want to help you gain and maintain your professional certifications. You can study, learn, and earn – it’s simple!
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