Procurement Management Procurement management helps you plan your activities such as what to get done from outside, how to identify a seller and what kind of contract should be used. Procurement management involves lot of activities and some of them involve mathematical calculations as well. As a project manager it is your responsibility to understand these processes well. In this chapter I will discuss the procurement concepts that require mathematical calculations. 1 hope after completing this chapter you will be able to solve mathematical questions on the procurement management knowledge area. Okay, let's get started. Types of Procurement Contracts You can divide the procurement contract into three categories: 1) Fixed Price Contract 2) Cost Reimbursable Contract 3) Time and Material Fixed Price Contract In a xed price contract, once the price of the contract is decided and the contract is signed, it cannot be changed. Now the seller is legally bound to complete the task within the agreed amount. If the cost escalates, it will be on the seller's account. Fixed price contracts are considered to be risky for sellers. Fixed price contracts can further be divided into three types: 1) Finn Fixed Price (FFP) 2) Fixed Price Incentive Fee (FPIF) 3) Fixed Price with Economic Price Adjustment (FP-EPA) Firm Fixed Price Contract (FFP) In this case, once the contract is signed for a denite fee, the seller has to complete the job for this agreed amount of money. Any cost overrun will be home by the seller. This is the most risky contract for the seller and the least risky contract for the buyer. Fixed Price Incentive Fee (FPIF) Here the contract price is xed, however the seller will be given an additional incentive fee based on their performance. Although this is a type of xed price contract, the nal price of the contract is not xed here. It depends on the performance of the seller and agreed terms. The terms used in this type of contract: Target Cost: This is the anticipated cost of the contract. Target Prot: This is the agreed prot at the target cost. Target Price: This is equal to target cost plus target prot. Ceiling Price: This is the maximum price the buyer will pay. Once it is reached, the seller will bear the cost. Share Ratio: This is expressed as (buyer ratio)/(seller ratio); for example 80/20. This ratio tells us that if the contract is completed below the ceiling price, the buyer will keep 80% of it and the seller will get 20%. If the price crosses the target cost and reaches the ceiling price the buyer will bear 80% and the seller will bear 20%. Once the ceiling price is crossed, the seller will bear all costs. Example You sign a FPIF contract with a contractor with the following conditions: Target Cost = 400,000 USD Target Prot = 50,000 USD Target Price = 450,000 USD Ceiling Price = 500,000 USD Share Ratio = 75/25 The contractor completes the contract for 375,000 USD. Calculate the actual prot received by the seller, and what is the actual price of the contract? Solution The target cost was 400,000 USD and the contractor has completed it for 375,000 USD, therefore there is an underrun of 25,000 USD. Since the ratio of the seller is 25%, he will get the 25% of this 25,000 USD. Contractor's ratio on saving = 25% of 25,000 = 6,250 USD The target prot is 50,000 USD and the contractor's share on saving is 6,250 USD, so the total prot will be equal to sum of these two. Total Actual Prot received by the seller = 50,000 + 6,250 = 56,250 USD Actual price to contractor = Actual cost + actual prot = 375,000 + 56,625 = 431,625 USD Please note that since the actual price is lower than the ceiling price you will get exactly 431,625 USD. However, if this would have been more than the ceiling price, you will get the ceiling price only, i.e. 500,000 USD. Practice Question: 1 You sign a FPIF contract with a seller with the following parameters: Target Cost = 420,000 USD Target Prot = 40,000 USD Target Price = 460,000 USD Ceiling Price = 525,000 USD Share Ratio = 60/40 The contractor completes the contract for 440,000 USD. Calculate the actual prot received by the seller, and what is the actual price of the contract? *** Point of Total Assumption (PTA): This concept is used in Fixed Price Incentive Fee (FPIF) contract types. The Point of Total Assumption is the point above which cost is home by the seller. In this type of contract, there is a ceiling cost, which considers the worst case scenario. If the seller crosses this cost, it is assumed that this cost has overrun due to mismanagement on the part of the seller, and it is his responsibility to bear this cost overrun. Here is the formula to calculate the Point of Total Assumption: Point of Total Assumption (PTA) = ((Ceiling Price Target Price)/Buyer's Share Ratio) + Target Cost Example: With the following information on hand, calculate the Point of Total Assumption. Target Cost = 100,000 USD Target Prot = 10,000 USD Target Price = 115,000 USD Ceiling Price = 120,000 USD Share Ratio = 80% buyer, and 20% seller Point of Total Assumption (PTA) = ((Ceiling Price Target Price)/Buyer's Share Ratio) + Target Cost Point of Total Assumption = (120,000 100,000)/0.8 + 100,000 = 25 ,000 + 100,000 = 125,000 Hence, the Point of Total Assumption is 125,000 USD. ##33 Practice Question: 2 With the following information on hand, calculate the Point of Total Assumption. Target Cost = 375,000 USD Target Prot = 25,000 USD Target Price = 400,000 USD Ceiling Price = 450,000 USD Share Ratio = 75% buyer, and 25% seller *** Fixed Price with Economic Price Adjustment Contracts (FF-EPA) If the duration of the contract is very long, a Fixed Price with Economic Price Adjustment Contract will be used. Here you include a special provision in a clause which protects the seller 'om ination. Cost Reimbursable Contract Here the seller is reimbursed for their work plus a fee representing their prot. Sometimes this fee will be paid if the seller meets or exceeds the selected project objectives. This contract can be further divided into four categories: 1) Cost Plus Fixed Fee Contract (CPFF) 2) Cost Plus Incentive Fee Contract (CPIF) 3) Cost Plus Award Fee (CPAF) 4) Cost Plus Percentage of Cost (CPPC) Keep in mind that in a cost reimbursable contract there is no ceiling price because the seller is going to be reimbursed for all of their costs. Cost Plus Fixed Fee Contract (CPFF) Here the seller is paid for all their costs incurred plus a xed fee (which will not change), regardless of their performance. In this case, the buyer bears the risk. This contract is used in situations when risk is high and no one is interested in bidding. This type of contract is selected to keep the seller safe from risks. Cost Plus Incentive Fee Contract (CPIF) Here the seller will be reimbursed for all costs plus an incentive fee based upon achieving certain performance objectives mentioned in the contract. This incentive will be calculated by using an agreed predetermined formula. In this contract the risk lies with the buyer; however, this risk is lower than the Cost Plus Fixed Fee where the buyer has to pay a xed fee along with the cost incurred. The terms used in this type of contract: Target Cost: This is the agreed anticipated cost of the project. Target Fee: This is the agreed fee as mentioned in the contract. Share Ratio: This is expressed as (buyer ratio)/(seller ratio). For example 80/20. Please note that in this contract the minimum and maximum fee is mentioned. So in any case you will not get less than the minimum fee and more than the maximum fee. Example You sign a CPLF contract with a seller with the following parameters: Target Cost: 500,000 USD Target Fee: 50,000 USD Share Ratio; 80/20 Maximum Fee: 75,000 USD Minimum Fee: 25,000 USD The seller completes the work for 550,000 USD. How much will the seller receive? Solution The target cost is 500,000 USD and the seller has completed the work for 550,000 USD, therefore there is a cost overrun of 5 0,000 USD. Since your share ratio is 20%, you will have to bear 20% of this 50,000 USD, and this amount will be deducted from your target fee. Your share on overrun = 20% of 50,000 = 0.2*5 0,000 = 10,000 USD Actual fee given to you = Target Fee - Your share on overrun = 50,000 - 10,000 = 40,000 USD Since this fee is between the maximum and minimum fee, you will get 40,000 USD. Actual price to the seller = Actual cost + actual fee = 55 0,000 + 40,000 = 590,000 USD Therefore the actual price paid to the seller is 590,000 USD. Please note that in this type of contract your fee will never be lower than the minimum fee and more than the maximum fee. If the calculated fee is less than the lower fee you will get the lower fee, and if the calculated fee is higher than the calculated fee you will get the maximum fee. *ilul Practice Question: 3 You sign a CPIF contract with a seller with the following parameters: Target Cost: 200,000 USD Target Fee: 20,000 USD Share Ratio; 70/ 30 Maximum Fee: 30,000 USD Minimum Fee: 10,000 USD The seller completes the work for 180,000 USD. How much will the seller receive? *0"? Cost Plus Award Fee (CPAF) In this type of contract, the seller is paid for all costs plus an award fee. This award fee will be based on achieving satisfaction on performance objectives described in the contract. The evaluation of performance is a subjective matter and you cannot appeal against it. There is a difference between an incentive fee and an award fee. An incentive fee is calculated based on a formula dened in the contract, and is an objective evaluation. An award fee is dependent on the satisfaction of the client and is evaluated subjectively. An award fee is not subjected to an appeal. The terms used in this type of contract: Estimated Cost: This is the estimated cost of the contract. Base Fee: This is the minimum prot that the seller will receive. Award Fee: This is the award fee that the contractor will receive aer achieving certain performance objectives. Cost Plus Percentage of Cost (CPPC) Here the seller is paid for all costs plus a percentage of these costs. This type of contract is not preferred, because the seller might articially increase the cost to earn a higher prot. Time and Materials Contract This contract is generally used when the deliverable is \"labor hours.\" Here the project manager or the organization will provide the qualications or experience to the contractor to provide the staff. A time and materials contract is used to hire experts or any support services. This contract is a hybrid of xed price and cost reimbursable contracts. Here the risk is distributed to both parties. Example: 1 You are planning to rent drilling equipment with rental cost of 500 USD per day. This is costly equipment to purchase at 100,000 USD. Since you are going to use this equipment for a very long time, you are analyzing whether to buy this equipment or not. Calculate after how many days the rent paid will be equal to the cost of the equipment. Solution Let's say that after \"N\" days the cost of rent will be equal to the cost of the equipment. Therefore, 500*N = 100,000 N = 100,000/500 = 200 Therefore, aer 200 days the cost of rent will be equal to the cost of the equipment. intuit Example: 2 You are planning to rent a transport vehicle for a few days. The daily rent for this vehicle is 60 USD and daily operating cost is 40 USD. This is costly equipment to purchase at 70,000 USD. Since you are going to use this vehicle for a very long time, you are analyzing whether to buy it or not. Calculate after how many days the rent paid will be equal to the cost of the vehicle. Solution Let's say that after \"N\" days the cost of rent will be equal to the cost of the vehicle. Therefore, 60*N = 70,000 + 40*N 20N = 70,000 N = 70,000/20 = 3,500 Days Therefore, after 3,500 days the cost of rent will be equal to the cost of the vehicle. Practice Question: 4 For your ofce work you need a high end photocopy machine which is available to rent for 150 USD per day and the operating cost is 25 USD. The price of this machine is 125,000 USD. You will need this machine for several months, therefore you start calculating whether you should purchase it or not. Calculate the number of days after which it would be advisable to buy this machine. *Fkii' Practice Question: 5 Your organization has signed a cost plus incentive fee contract with a seller. The cost of the contract is 100,000 USD and the target prot is 10% of the target cost. The seller's share ratio is 25% and has spent 90,000 USD to complete the task. Calculate the prot and actual price paid to the seller. *0\": Practice Question: 6 Your company has signed a xed price incentive fee contract with a seller with the following details: Target Cost = 300,000 USD Target Incentive Fee = 50,000 USD Share Ratio = 70/30 Ceiling Price = 400,000 USD Actual Cost = 320,000 USD Calculate the actual price paid to the seller