Hence, in the cost reimbursable model, the service provider has little or no incentive to control costs as they are charged back to the client. Cost reimbursable contracts carry the highest amount of risk to the client organization, as the total costs cannot be predicted in advance. To avoid discrepancies, an estimate of total cost is established a priori to establish a ceiling, on the total costs the service provider may incur without further client approval and to ensure that the service provider may exceed this limit at its own risk. Under the cost-reimbursable contract, the service provider agrees to provide its best effort to deliver the required effort within the set ceiling limit.
Cost reimbursable contracts are used when there is a lot of uncertainty regarding the project, when a large investment must be made in the project well before completion of the project, and when there is a high amount of risk.
1. Cost plus Fixed Fee (CPFF)
The cost plus fixed fee model permits the service provider to charge back all costs associated with project performance to the outsourcing organization and to take an agreed upon fixed fee upon project completion. The fixed fee portion is how the service provider makes money on the deal. In this form of contract, the fee is almost always fixed, but the costs are variable. Hence, the service provider does not necessarily have a lot of motivation to control costs with this type of contract. The only motivation to complete the project is driven by the fixed fee portion of the contract.
A CPFF contract may take one of the two basic forms:
1. CPFF completion contract
2. CPFF term contract
1.1. The CPFF completion contract
This form of contract requires the service provider to deliver a specific product or service delivery within the estimated cost as a condition for earning the fixed fee portion of the contract. However, if the service provider cannot deliver the scope within the estimated cost limits set in the contract agreement, the client may mandate the service provider to complete the entire scope without any increase in the fixed fee part, which eventually decreases the service providers’ overall profit margin.
1.2. The CPFF term contract
This form of contract obligates the service provider to allocate a specified level of effort defined in the Service Level Agreement (SLA) for a specified duration. If the client considers the service provider’s performance satisfactory, then the fixed fee is paid at the end of the contract term rather than at the end of the entire project. Further contract renewal is subject to cost and fee revisions based on performance baselines.
1.3. Cost plus incentive (CPI) contract
The cost plus incentive model is very similar to the CPFF contract in that only an incentive is added to motivate the service provider exceed the performance criteria laid out in the contract. The measurement criteria for evaluating performance must be clearly articulated in the contract and ratified to by both parties.
The incentive may be calculated either as a specific percentage of the total project cost or by some other metric that compares estimated project costs to actual project costs. CPI contract is the riskiest of all contracts for the client organization because it cannot predict or the service provider cannot guarantee what the total final costs will be. Furthermore, since the profit to the service provider is a specific percentage of the total project cost, there is absolutely no incentive for the service provider to optimize costs or operations.
> Read here soon in the next part about the Time and Materials (T&M) model
About the author: Mithun Sridharan is a General Manager at BlueOS LLC, an advisory based in Germany, where he is res pons ible for driving the s trategic s ales initiatives and managing cus tomer engagements in Digital transformation & Analytics. Prior to BlueOS, he was an Account Manager with Oracle Corporation, where he drove strategic partnerships with key enterprise accounts and major Independent Software Vendors in Europe and the USA. He brings with him over a decade of International experience in Management Consulting, Business development, Strategic Marketing & Product Management. He holds an MBA from ESMT Berlin and a Master of Science (MSc) from Christian Albrechts University of Kiel. He is a Harvard Manage Mentor Leadership Plus graduate, an SAP certified Business Intelligence Professional, a Project Management Professional (PMP) and a Certifed Information Systems Auditor (CISA). He also served as the Communication Chair for the German Outsourcing Association in 2013 and is based in Heidelberg, Germany.
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Picture: Aneta Blaszczyk, Poland