Why are there more claims in fixed price contracts? Should not there be less claims in fixed price contract?

Question

A claim is an assertion that the buyer did sth wrong that has hurt the seller and seller is asking for compensation.

Imagine the number of claims that can arise if you are working with a fixed price contract and an incomplete statement of work.

I understand that there will be more claims in incomplete statement of work, because seller will always feel buyer is hurting him by asking to do more work not in contract(SOW).

But what about fixed price contract? Since the price is fixed, should not there be less claims? Or is it the way of getting profits in fixed price contract by nasty sellers? Please explain.

Answer 1

You seem to be decoupling the concept with an incomplete SOW with an FFP-type contract as if sellers levy claims for one or the other in an exclusive way. An FFP-type contract, itself, does not cause an increase in claims. The claims are secondary to many other issues--an incomplete SOW being only one of them--where an FFP-type contract can exacerbate the loss--perceived or real--the seller is experiencing.

In other types of contracts, both parties have skin in the game to control costs. In a T&M contract, there can be motivation for a seller to grow costs because that becomes extra revenue for them; however, it can be mitigated by funding limits, NTE limits, or even reputation capital. For FFP-type contracts, the cost risk is solely owned by the seller. (In reality, the buyer does assume costs risks for an FFP but in a different way.)

So since there is a near 100% transfer of risk to the seller, that necessarily means the seller must control what is practically uncontrollable to ensure they will at least break even. If the buyer does not perform as contractually required, then the seller needs to intervene in some way to protect their interests. And that can end up with a legal claim.

Answer 2

A fixed price contract usually means that payment is tied to a successful outcome and therefore it sets up some expectation of service (perhaps a very complex expectation) which, if not met, means that the customer may not want to pay at all.

Other types of contract usually involve staged or periodic payments. If the customer is dissatisfied they can walk away but the expectation is usually that payments made for services rendered up to that point are a sunk cost.

This is a view based on practical experience, not law. The legal details of course will vary depending on the contract terms. I am not a lawyer.

Answer 3

Sellers are neither nasty nor nice; both sides are negotiating for their own advantage. Fixed price transfers all the risk from the buyer to the seller.

When a contractor bids a fixed price job, it has to make a series of assumptions about what its direct costs to complete the job will be, what portion of its fixed and variable indirect expenses should be allocated to the job, and what amount of profit, if any, should be included in its bid price, taking into account the competition it faces, and its need for the work. In theory, the contractor is either given, or is able to obtain, sufficient information about the job, and the restrictions under which it will have to be performed, to enable it to make correct assumptions, and to accurately estimate what its costs will be.

COST ASSUMPTIONS

There are many times, however, when a contractor’s cost assumptions are based on incomplete information, or are based on reasonable but mistaken beliefs about what the owner will do to facilitate the performance of the work. When that happens, the contractor often incurs substantial additional costs that it did not anticipate, and wants to submit a claim for additional money to the owner. mcsmag

The seller's best option is to plan thoroughly and cleverly, and this is what both parties are hoping that the seller does; the price negotiation is, in part, the two parties agreement on the quality of the seller's planning. If the planning is done right, all the possible exigencies will be covered, and the work will be completed in a way that matches their mutual expectations about quality and profit.

But given that all planning is imperfect, when the unexpected occurs, the consequences have to fall on someone. Except in rare occasions, neither side is enthusiastic about claims - but sometimes claims are a rational, prudent response to exigencies.

"Courts have also recognized the risk-shifting mechanism of fixed-price contracts. “Unlike the cost-reimbursement type contract in which the government bears the burden of all allowable costs, the burden is shifted entirely to the contractor in a fixed-price contract,. . . ” jdsupra

Aside: the case law referenced in the above article contain multiple examples of the buyer attempting to use "claims" to claw back money from a seller whose superior planning enabled them to make an unanticipated profit. These claims appear to be denied.

Fixed price/lump-sum contracts In this type of contract, the seller assumes the greatest risk because the price is set. This means that the seller must comply with the contract and provide the service/product for a specific price. If the time it takes to deliver the service/product expands, the seller cannot charge for the extra time. The same would be true if extra materials were needed to deliver the service/product. If this occurs, the seller cannot charge for the extra materials because the price for the contract is already fixed. flylib.com