Fixed-Price Contracts are issued when there is a reasonable degree of certainty that costs and profit can be accurately forecasted; thus utilizing the profit motive in any business. The government favors fixed price contracts because the cost is determinable before the project starts and because a fixed price carries less risk of overspending than cost plus contracts. Fixed price contracts allow the Government to hold the lowest risk whereas the contractor carries the highest performance risk. Fixed price contracts place all of the pressure on the contractor to perform within budget if they wish to realize any profit on the contract.
If you are seeking a fixed price contract, it is critical to evaluate whether your company can accurately forecast and project costs and the intended profit. Inaccurate job cost estimation can lead to significant losses that will leave a business bleeding cash. If your company does not have the capability to accurately project cost and profits, a cost plus contract should be pursued to minimize the risk of incurring a loss. (TGG will be able to establish the procedures and analysis necessary to help your business accurately project costs and profits for individual contracts).
Politics aside, government contracts are entered with the intention to protect the tax payer from unnecessary spending. In order to fulfill that mission, certain conditions must exist to warrant a fixed price contract. The first condition requires adequate price competition and bidding. This allows the government to accept a fair and reasonable price. The second condition requires reasonable price comparisons with either similar supplies or services or comparisons with prior purchases. Again, this requirement is used to help the government budget a fair and reasonable price. The third requirement requires reasonable estimates of cost. Cost estimation is the essential aspect of fixed fee contracts to ensure that both the government and the contractor are not taken advantage of. The fourth and last requirement is the contractor’s identification, acknowledgement, and risk acceptance of any performance uncertainties.
Fixed price contracts can have an adjustable price. Fixed adjustable price contracts help to protect the contractor from economic shifts that our outside of their control. Adjustable contracts are only issued when the contracting officer determines that the contractor and or government need to be protected from significant fluctuations in labor or material costs. The contracting officer will specifically include a clause to establish an “Economic Price Adjustment”. Contracts with an adjustable price will typically include a ceiling and or target price. Target price is the estimated final cost the contractor is striving to achieve whereas the ceiling cost represents the highest reasonable and foreseeable final cost. At the end of the contract, the ceiling and target prices are compared to see if the project was completed within budget. Adjustable price contracts are typically used when there is serious doubt about the stability of market and or labor conditions that will arise during the duration of the contract. Contract prices will only change with the occurrence of specific contingencies such as adjustments to established prices, actual labor and material costs, and indexes of labor or material. Price contingencies are restricted to industry wide trends beyond the contractor’s control.
Understanding what type of contract your business may be entering into is critical to success. For help with fixed price contract accounting or any other type of contract accounting, contact TGG Accounting today.Written by: Jake Cavanagh TGG Accounting