What is contract pricing?
What are the different contract pricing types and models used to price a contract?
What are the common pricing techniques?
In this article, we will break down contract pricing and look over the most common contract pricing models, types, techniques and strategies.
Are you ready?
Let’s dive right in!
What is contract pricing?
Contract pricing is a method, strategy or tactic to price the services of work or delivery of a project.
Contract pricing is important is it allocates risk and financial responsibility to either contractual parties.
In a time and material contract pricing model, the financial risk of a project is on the client and the contractor assumes little to no risk.
In a fixed-fee-firm contract, the financial risk is entirely on the contractor and the client expects the work to be done for a firm flat rate.
Having a good understanding of contract pricing will allow you to adequately evaluate your options, risk and effort to ensure you remain profitable in the work that you do.
Let’s look at some different types of contract pricing models.
Different types of contract pricing
There are different types of contract pricing arrangements.
Depending on the project, the work and risk, contractual parties may favour one model over another.
Here are some of the common pricing models worth noting.
Cost-reimbursement pricing (CRP)
The cost-reimbursement pricing model is where the client will assume the costs of the project incurred by the service provider.
Clients should be careful as the service provider or contractor may not have an incentive to control project costs.
Turnkey contracts
A turnkey contract is a contract where the service provider will charge a certain amount and will handle all aspects of the work including elements like design, material, performance.
The client relies on the service provider’s ability to handle the work from inception all the way to completion.
A turnkey contract can be fixed price as it is the service provider that scopes, performs and delivers the work.
However, the pricing can also be handle in other ways such as time and material or cost-plus.
Bills of quantities
Bills of quantities are lump-sum contracts where the service provider provides an outline of material, parts and labour.
The rates can be approximations or firm.
These types of contracts are used in construction work.
Time and material (T&M)
A time and material contract is a type of contract pricing model where the client will cover the costs of the material required in the project and will pay the service provider a specific rate per hour, day or month.
This is a type of contract pricing shifting the risk from the service provider to the client.
To mitigate the client’s risk, in some cases a not-to-exceed cap can be negotiated in the contract.
Lump-sum fixed price (LFP)
A lump-sum fixed price is a fixed price contract where the party rendering the services will need to fulfill the contractual obligations in exchange for a fixed price as stated in the contract.
To properly set a price in a fixed-price contract, the service provider should have a good understanding of the work, the scope and the deliverables in general.
In most cases, the offering of a fixed price requires that the parties exchange project information or information related to the services and requirements allowing the service provider to adequately evaluate the project costs, risks and timelines.
Unit rate (UR) or unit price (UP)
Unit rate or unit price contracts provided the rate for a measurable amount of work.
The price of the contract will be a function of the work measured.
This type of contract pricing works well when the full scope of a particular project is unknown but the measure of each unit of work is clear.
For example, a software company can sell data usage on the basis of how many gigabytes are used.
The value of the gigabytes of data is clear but it’s not sure how much the client will consume.
Day rate or time rate
The daily rate or time rate is a type of contract pricing where the rate is defined as a function of time.
Depending on the amount of time it takes to deliver a project or render a service, the total contract price will vary accordingly.
You can have monthly, weekly, daily or hourly rates.
This type of pricing works well when the full scope of the work is not measurable but the cost per unit of time is clear.
For example, litigation lawyers will charge an hourly rate to work on a lawsuit.
The rate per hour is defined but the total amount of time it may take to complete the mandate is unknown.
Cost-plus pricing
The cost-plus pricing is a type of pricing where the service provider’s full costs will be covered by the client along with a payment of incentive providing the profit if the service provider.
Generally, the incentive is paid during the life of the project as the project advances or milestones are achieved.
The costs should be clearly defined so that it’s clear what the client may need to reimburse.
The direct costs are obvious such as material and other costs directly required to deliver the project.
However, the service provider can incur indirect costs or overhead charges.
It’s important to factor that into the contract pricing.
Cost-plus-fixed-fee (CPFF)
A cost-plus-fixed-fee contract is a type of contract where the service provider’s costs are fully paid by the client and the service provider gets a fixed fee for the work performed.
This type of contract is useful for research contracts or exploration studies for example.
Fixed-price incentive (FPI)
The fixed-price incentive contract is a type of contract where the pricing includes an incentive to the service provider to achieving better cost targets than the planned costs.
The contract will include a formula whereby the profit of the service provider will vary depending on the ratio of the final project costs versus the negotiated costs.
Fixed-price incentive firm (FPIF)
The fixed-price incentive firm is similar to the fixed-price incentive but the target costs and profits are firm.
Fixed-price incentive successive (FPIS)
The fixed-price incentive successive is similar to the fixed-price incentive firm with the difference that the target costs and target profits are not firm.
Generally, when the contract reaches a certain pre-defined production point, the contract will become a fixed-fee-price (FPP) or a fixed-fee incentive firm (FPIF).
Fixed-price award fee (FPAF)
A fixed-price award fee is generally offered by governments in cases where the work tcannot objectively be predetermined in order to properly scope the effort and costs.
The contract will include a formula on how the service provider’s fee may be potentially calculated.
This is a rare form of contract pricing.
Cost-plus-award-fee (CPAF)
This is a type of contract pricing where there is a base fee along with an award fee.
The award fee can be paid out during the project as the project advances or achieves different milestones.
Fixed-price with economic price adjustments (EPA)
This is a type of contract where the contract price is fixed except that the costs can be increased or decreased based on economic factors affecting cost of labor, material or other defined costs.
Guaranteed maximum price (GMP)
A guaranteed maximum price, as the name says it, it’s a pricing model where the price cannot exceed a certain value or threshold.
This type of contract can offer some protection to the contractor who can increase the price to a certain extent up to the maximum.
It also gives comfort to the client that the prices will not indefinitely go up.
Contract pricing techniques and methods
There are five common pricing techniques or methods used to price a contract:
- Cost-plus pricing
- Competitive pricing
- Value-based pricing
- Price skimming
- Penetration pricing
Let’s look at each.
Cost-plus pricing
The cost-plus pricing method is where the service provider evaluates a contract price based on how much it may cost to render the services or do the work and adds a mark-up or a fee.
Competitive pricing
Competitive pricing is a type of pricing strategy where the service provider evaluates what the competitors are pricing for the same work a tries to offer competitive rates.
Value-based pricing
Value-based pricing is a pricing technique where the service provider evaluates the cost of a project based on the value the services can bring to the client or how much the client believes the services are worth.
Price skimming
Price skimming is a strategy where the contractor puts a high price on the contract and slowly reduces the costs as the market evolves.
The price is “skimmed” as the project advances.
Penetration pricing
Penetration pricing is sort of the opposite of price skimming where the contractor sets a low price to penetrate a market and slowly starts raising prices.
Contract pricing proposal
A cost pricing proposal is a proposal made by one party to another outlining the contract requirements, effort, material and pricing.
Generally, a proposal is prepared to respond to an RFP.
The proposal should contain a description of the client requirement, the scope of the work, the costs per unit or relevant aspects of the pricing proposal along with the cost estimate, proposal or firm pricing.
Takeaways
Contract pricing is a method, strategy or tactic to price the services of work or delivery of a project.
Contract pricing is important is it allocates risk and financial responsibility to either contractual parties.
There are different types of contract pricing arrangements.
In this article, we covered:
- Cost-reimbursement pricing (CRP)
- Turnkey contracts
- Bills of quantities
- Time and material (T&M)
- Lump-sum fixed price (LFP)
- Unit rate (UR) or unit price (UP)
- Day rate or time rate
- Cost-plus pricing
- Cost-plus-fixed-fee (CPFF)
- Fixed-price incentive (FPI)
- Fixed-price incentive firm (FPIF)
- Fixed-price incentive successive (FPIS)
- Fixed-price award fee (FPAF)
- Cost-plus-award-fee (CPAF)
- Fixed-price with economic price adjustments (EPA)
- Guaranteed maximum price (GMP)
Depending on the project, the work and risk, contractual parties may favour one model over another.
You should also know that you can price contracts using five different techniques:
- Cost-plus pricing
- Competitive pricing
- Value-based pricing
- Price skimming
- Penetration pricing
Depending on your negotiation power, market position and competition, you should use the pricing technique more favourable to you.
You should be equipped with the contract pricing basics so you can better scope your projects and ensure you are profitable.
