Firm Fixed Price Contracts provide a price that is not adjustable based on the cost of the project for the supplier. The contract is only appropriate when a fair and reasonable price can to be determined which usually indicates there has to be a competitive market place and comparable fair value supplies. The Firm Fixed price is the lowest risk contract for the government because their receivable is determined in the contract and the risk of not receiving the product is minimal. It is the highest risk for the government supplier because their supply is fixed but managing cost to be profitable is extremely risky for fixed projects.
Another variation of the Firm Fixed Price Contract is the Fixed Price Incentive Fee Contract. The contract provides an adjustable profit based on the relationship between the final negotiated cost and the target cost. Fixed price contracts with economic price adjustments allow for revisions of price based upon specific contingencies. The adjustments can be based upon three contingencies: established price, the actual cost of the labor or material, or the cost indexes of the labor or the material. The contracting office may use these economic adjustments and incentives in conjunction with the fixed price when adjustment or incentive is based on solely on factors other than cost. The contract type remains fixed price even with these incentives and adjustments.
An additional type of Firm Fixed Price Contract is used based on the level or work provided. It is called the Fixed Price Level of Effort Contract. The contractor is to provide a specified level of effort over a determined period of time that can really only be described in general terms in the contract. The government pays the contractor a fixed dollar amount based on the amount of work performed. The fixed price contract based on level of effort vary from previously discussed fixed price contracts because in prior examples the risk of the contract was placed on the contractor because its cost was indeterminable while its revenue was fixed. Now, for the contractors, both revenue and cost are fixed so they can control and accurately determine its margin which allows the ability to achieve secure profits. For the government in a fixed price contract based on level of effort, the output of worked received is a variable because while they know how much time will be provided from the contractor the tangible result and product can vary depending on the talent of the workers.
To summarize, fixed price contracts generally favor the government because the variable of cost is placed on the contractor and it is the contractor job to manage the project profitably once the contract has begun. However for contract based upon level of effort, the risk switches from the contractor to the government. For incentive and adjustment based fixed contracts, they are classified as fixed because although a portion of the price is not determined when the contract is created, the majority is determined and provides reasonable assurance of the positive outcome for both government and contractor.Written by: Marcus van Leeuwen TGG Accounting