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What a fixed price contract in simple terms?
How does it work?
In this article, I will break down the meaning of Fixed Price Contract so you know all there is to know about it!
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Let me explain to you what are fixed price contracts and why they are important!
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What Is Fixed Price Contract
A fixed price contract is a type of contract where the party rendering goods or services contractually sets the price at which the goods or services will be sold or provided.
In other words, the seller charges a fixed price for the goods or services and the buyer accepts to pay a definitive price to receive the goods or services.
In the business world, getting into a fixed price agreement is quite common, particularly when the scope of the work to be done is clear upfront and the cost of producing the goods or rendering the services is known with a high degree of certainty.
When the seller agrees to a “fixed price” contract, it means that the price to be paid by the client will not change no matter the circumstances of the contract.
In essence, the seller will absorb the cost of overruns, extra materials, or higher production costs as it can no longer pass that on to the client.
Fixed Price Contract Definition
How do you define fixed price contract?
A fixed price contract is a type of contract where the contract priced in such a way that the buyer and seller know exactly what is the total price of the contract upfront without the possibility of the pricing changing in the future.
For example, a service provider can enter into a fixed price contract to deliver services for a specific project.
Upfront, the client and service provider negotiate and agree on the total service price and have that fixed for the entire term of the contract.
Other Fixed Price Contract Names
In the business world, there may be different names used to refer to fixed price contracts, such as lump-sum contract, fixed-price agreement, fixed-fee contract, fixed-sum contract, or other.
It’s important to understand the true nature of your contract rather than relying on the title.
If the parties to a contract agree to specific obligations at a specific price without the possibility of that price changing, then you are likely dealing with a “fixed price” contract.
When To Use Fixed Price Contracts
In certain cases, you will want to leverage a fixed price contracting model whereas at other times you will want to stay away from it.
Every business transaction is different making it important for you to assess what is the best contractual setup that balances simplicity with adequate legal protection.
When is it more appropriate to use fixed price contracts?
In essence, you’ll want to use a “fixed price contract” when dealing with simpler projects, the delivery of specific goods, or engaging in a business transaction that you can understand its scope and costs with high degrees of certainty.
- A simple service contract
- The delivery of specific goods that are produced in a routine manner
- Service contracts where you can access labor and material easily and with price certainty
- Projects that have very little “unknowns”
Types of Fixed Price Contracts
What are the different types of fixed price contracts?
There are different types of fixed price contracts, namely:
- Firm fixed price contract
- Fixed price incentive contract
- Fixed price contract with an escalation
- Cost-plus-fixed-fee contract
- Fixed-ceiling price contract
Firm Fixed Price Contract
A firm-fixed-price contract is a type of contract that shifts the maximum level of risk onto the vendor and the minimum risk onto the customer.
In this type of contract pricing model, the contract provides for a price that is not subject to change no matter the vendor’s cost experience during the performance of the contract.
The project cost risk is therefore fully assumed by the vendor.
Fixed Price Incentive Contract
A fixed-price incentive contract is a type of contract pricing model where the contract provides for a fixed-price while allowing an adjustment to the final contract price based upon an agreed formal taking into account the final negotiated cost and the total targeted cost.
In essence, this type of contract will provide a financial reward or incentive to the seller for the defined criteria related to its performance.
Fixed Price Contract With Escalation
A fixed-price contract with escalation is a type of contract that will fix the price of the service to be rendered with a possibility to revise the pricing upwards if certain price fluctuations defined in the contract were to occur.
This type of contract pricing is used when the delivery of the services will span over a few years potentially having an impact on the market costs and expenses.
A cost-plus-fixed-fee contract is a type of contract where the contractor is paid for the normal expenses for the project along with an additional fee for the services rendered.
This type of contract can result in the contractor not having any incentive to control the cost of the project as this cost will be reimbursed by the client in full.
Fixed-Ceiling Price Contract
A fixed-ceiling price contract with redetermination is a type of contract where the price ceiling is established by the parties in the contract.
However, the price can be redetermined at mutually agreed intervals.
This is effective when you can properly forecast pricing and costs for the current period only giving you the ability to adjust pricing in future periods.
Fixed Price Contract Advantages And Disadvantages
What are the advantages and disadvantages of fixed price contracts?
The main advantage of fixed price contract is that there’s price certainty for the parties.
This tends to favor the client more than the service provider or seller.
When a client and service provider agree on the terms of service at fixed price, no matter what happens, the client will only be accountable to pay the price agreed in the contract.
The seller cannot ask the client to pay more no matter what happens.
Once a fixed price contract is signed, the buyer knows what will be delivered and at what price and the seller knows what to deliver and at what rate.
A fixed fee contract is a type of contract that is generally easier to manage.
If you are selling goods, you’ll need to be clear as to the goods being delivered, their quantity, their quality (to the extent that’s relevant), delivery date, and price, among other things.
Once that’s defined, then both parties know exactly what to do and what to expect.
If you are selling services, you’ll need to define the scope of the project, the deliverables, the price, and delivery date.
The buyer and seller will not have to track time, track material costs, and other aspects of the project and will not have to agree on the contractual logistics surrounding that.
It’s irrelevant to the buyer how much time the seller puts into services or how much the material costs as the seller is to deliver the services based on the fixed price mutually agreed upon in the contract.
Fixed Price Contract Risk
It’s important to note that vendors or sellers will assume the fixed price contract risk more than the clients.
The reason is simple.
No matter what, the seller is legally bound to deliver the goods or services at the price mutually agreed in the contract.
If the seller has to pay for more material, has unexpected expenses, has to spend more time on the project, or deals with cost overruns, that’s not the client’s problem.
Typically, sellers will only accept fixed price contracts when they can accurately forecast the requirements of the project and calculate their costs with certainty.
Otherwise, sellers will find another type of contract allowing them to pass on some risk to the client.
Negotiating Fixed-Price Contracts
Just like any other contract, when you’re looking to enter into a fixed price contract, it’s important that you looked at the fixed price contract pros and cons to make sure that you are comfortable with it.
Once you have a good understanding of the benefits and drawbacks of your fixed price contract, you’ll be able to make a better business decision relating to its scope, price, and other aspects of the contract.
Here are a few tips that you should keep in mind when you’re negotiating your fixed price contract.
Assess Contract Scope
The first thing you should do is to make sure that you know and understand all aspects of the contract allowing you to deliver the intended goods or services.
Do you know how long it will take to deliver, what material you need, how much labor resource will be required, will there be possible deviations etc?
The more you are certain about all the steps required to deliver the goods and services, the more you can easily calculate your internal cost and put a price tag on the contract allowing you to cover your costs and have a profit margin.
Assess Contract Cost
To make money with fixed price contracts, you’ll need to know how much the contract is going to cost you to fulfill your obligations.
The more you know your costs with certainty, the more you can negotiate a fixed-price contract.
However, if you cannot easily estimate your labor costs, cannot predict how much material you’ll need, or you cannot adequately evaluate the full scope of work upfront, then you will assume more risk with fixed-price contracts.
Include A Pricing Buffer
Once you have calculated your direct and indirect costs along with how much profit you are looking to make with the contract, you should always add a pricing buffer.
For example, if you estimate that you can deliver the project at a total cost of $7,500 and you’re looking to have a 25% profit margin, then you’ll want to price the project at $10,000 (where $7,500 goes to your cost and $2,500 to your profit).
However, it may be prudent to add an additional 10% buffer to your pricing so you can have an additional buffer in case you have overruns or unexpected costs, etc.
In this case, you should price the contract at say $11,500 where you are considering a 35% profit margin (by adding 10% to your profit margin).
Fixed Price Contract Change In Scope
In some cases, you may enter into a fixed-price contract but end up with surprises when you’re looking to fulfill your obligations.
Can you change the scope of your fixed price contract?
Both buyers and sellers must understand that you cannot change the terms of the contract (unless a specific agreement is reached or the contract provides for a scope change mechanic).
The buyer must understand that once the price is locked, it cannot be changed.
This means that buyers should make sure they are paying a fair price.
If a buyer pays a price that is significantly over market rates, the buyer will be stuck having to pay that amount.
As for sellers, they should make sure that they understand the scope of their obligations and have a good understanding of their costs.
If they have overrun, exceed budget, material prices change, labor prices go up, or have other surprises, they will not be able to change the contract price.
As such, fixed price contracts are great for simple engagements but do have risks.
Fixed Price Contract Example
Let’s look at an example of fixed price contract to better understand the concept.
Example 1: Renovation Contract
Let’s use a renovation contract to provide the first example of a fixed price contract.
Imagine that you are looking to renovate your basement and you enter into a renovation contract as follows:
- Scope: home basement renovation
- Price: $10,000 fixed price including labor and material
- Renovation duration: 2 weeks
In this example, the contractor charges a fixed price of $10,000 to renovate the basement including the cost of labor and material.
Example 2: Website Development Contract
In this example, you enter into a contract with a website developer to create and develop a website for you.
Here are the details of the contract:
- Scope: website development
- Price: $5,000 fixed price contract
- Delivery: 2 weeks
In this example, the website developer commits in creating a website for you within two weeks at a fixed price of $5,000.
This way, you’ll know exactly how much to pay for the creation of the site and there will be no surprises for you as the client.
Example 3: Inventory Purchase
If you are purchasing inventory where you know exactly how many units you need and at what price, a fixed price contract may be suitable for this transaction.
The buyer and seller will have to agree on:
- How many units
- Describe the goods to be purchased
- Price per unit
Fixed Price Contracts Takeaways
So there you have it folks!
What Is Fixed Price Contract
A fixed-price contract is a type of contract where the contract price does not vary throughout the term of the contract regardless of how many resources were used or time spent on the project.
In other words, the price in a fixed price contract is “fixed” for both parties where the buyer is obligated to pay that specific price and the seller can only claim that price.
Now that you know what is a fixed price contract, good luck with your research and contract negotiation!
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