Firm Fixed Price Contracts and Binding the Work

Question

For scope that is reasonably explicit, many customers choose to purchase services under a firm fixed price contract in order to remove cost risk. It is essentially transferring risk to the seller as a risk course of action. For this luxury, customers can typically pay a multiple somewhere between 10% to maybe as high as 50% than they would have paid under a different type of contract where cost risk is still borne by them.

Under this scenario, the seller now holds this risk. If they performed a proper probabilistic estimate on the work and conducted a thorough risk analysis, the seller would likely target and price more conservatively and capture in the price contingent dollars for unknowns.

How can work be bound such that there is a point where the seller's loss can be stopped? If the seller estimates between 12 and 25 cycles of work to produce the widget, most likley 15, and the seller conservatively targets and prices 18 cycles of work, would there be a way to include in the contract that anything above 20 cycles would require a change request?

If you had a stop loss for the seller, would it not be fair to have a stop loss for the buyer, e.g., if cycles only took 11, 12, or 13, the buyer gets a discount?

Or is it that, once a FFP is agreed upon, the seller has the risk no matter what and the only "stop loss" mitigators would be explicit finish criteria, firm buyer obligations, and a strong risk process?

Answer this question under the assumption that scope is under control and that changes to scope causes a change in both schedule and price; that the buyer's obligations are being met in full, meaning the increased cycles in work cannot be tied to something the buyer is or is not doing; and in an industry agnostic way. Thanks!

Answer 1

What you've described exists (in most part), but it's not a FFP contract, it's a "Cost Plus" or "GMP" (Guaranteed Maximum Price) type of contract. In this type of contract, the two parties agree that the Owner will pay the actual costs, plus a fixed price to the Contractor, up to an agreed upon maximum price. This price ceiling is generally the result of the Contractors estimating process and includes their risk assessment and contingency. Basically it's their belief that regardless of which risks present, they can complete the project under this price ceiling.

Under the GMP contract, the Contrator is still assuming the risk, as any cost overruns beyond the ceiling are absorbed by them (assuming they're not scope or change related). And because the contract is cost plus a fixed price, if they complete the contract under that ceiling, they only get the agreed upon fee, and any savings are retained by the Owner.

As for the increased cycles, you could just as easily negotiate the contact on a fixed number of cycles of attempts, with contingency for additional ones. There would need to be specific language that triggered the additional (why, cause, risks, etc.)

But again, this moves away from a FFP contract and into a Cost-Plus type. The FFP contract is used primarily to give the Owner a cap on the price - "it's going to cost us X". Adding in a contingency for additional cycles eliminates this and says "it will cost X, or maybe more, depending on how things go."

Answer 2

If the seller has signed off on such a contract and scope is under control they are stuck delivering what is within the scope of the contract.

The seller should be targeting a price that will be profitable the vast majority of the time, the corollary being that they are accepting a loss on a minority of their contracts. This loss would be more than made up for over a population of several projects, assuming all contracts are of similar dollar values. In the real world FFP costs for high-value contracts are heavily padded to ensure that the company doesn't take a big proportional loss on a single project.