Fixed-Price Incentive (FPI) is a contract that sets a fixed price, but profit fluctuates according to the work done. It ensures you keep to your budget and do the work on time without neglecting the main aims of the project.
The FPI contract is useful for both the government and contractors. This reduces the risk of financial loss and improves cost management. Contractors make more profit as long as actual costs decrease. When the company spends more money than planned, its profits decrease. It is necessary to set specific goals for expenses and results. The use of FPI contracts is common in the defence, aerospace and federal project sectors where strong accountability and discipline are needed.
How Fixed-Price Incentive Contracts Work?
Here are the three main situations and changes that are present in this contract. All of these factors contribute to the amount the contractor is paid.
- Cost underrun scenarios
- Cost overrun scenarios
- Profit adjustments
Cost Underrun Scenarios
When the contractor completes the project within the target cost, both parties share the savings. It encourages companies to make the most of resources and carefully watch their costs. The contractor gains by earning extra profits. The client is able to cut costs without having to reduce what is required. It makes the achievement of results the main basis for the contract payout.
This formula calculates how much profit is added based on the cost savings.
Formula:
Final Profit = Target Profit + (Contractor’s Share × (Target Cost – Actual Cost))
Cost Overrun Scenarios
When the actual amount of money spent is greater than the contract target, the contractor’s profit decreases. This tax break uses a set condition about how much you own. Some of the excess is handled by the client, yet some remains. Contractors are encouraged not to spend more than necessary. This method supports accurate predictions of resources and strict budget adherence during the whole project.
This formula shows how much profit is reduced due to the overrun.
Formula:
Final Profit = Target Profit – (Contractor’s Share × (Actual Cost – Target Cost))
Profit Adjustments
The amount of profit at the end depends on various factors. It reflects changes in cost performance. A decrease in spending means higher profits. An increase in costs leads to a fall in profit. The change is calculated using a fixed formula. It ensures balance in a company. It ensures contractors work toward the same financial goals as the client, allowing both parties to keep track of and answer for expenses.
Profit is adjusted based on actual cost performance and the share ratio.
General Formula:
Final Profit = Target Profit ± (Contractor’s Share × Cost Variance)
Where:
- Cost Variance = Target Cost – Actual Cost (positive for underrun, negative for overrun)
- ± means you add if underrun, subtract if overrun
What are the Types of Fixed-Price Incentive Contracts?
There are two main types of Fixed-Price Incentive Contracts:
- Fixed-Price Incentive (Firm Target) – FPIF
- Fixed-Price Incentive (Successive Targets) – FPIS
Fixed-Price Incentive (Firm Target) – FPIF
When making the contract, the target cost and target profit are decided in advance. Profit changes once actual costs are known. Each share the investor holds impacts how well overruns or underruns affect their profit. It sets the maximum cost the buyer can pay. It suits projects where the scope does not change and costs can be handled from the beginning.
Fixed-Price Incentive (Successive Targets) – FPIS
The process starts by picking a first target cost and profit. Both clients and contractors manage changes in the project as it develops together. Final calculations are done using actual data. It helps where costs cannot be predicted at the start. Flexibility increases with FPIS, but there needs to be a lot of oversight and frequent reviews as the contract is carried out.
What are the Benefits and Drawbacks of FPI Contracts?
Below are the four benefits and drawbacks of FPI Contracts:
- Encourages cost efficiency
- Risk-sharing mechanism
- Complexity in negotiation
- Requires precise cost estimation
Encourages Cost Efficiency
More profits can be earned by contractors when they deliver the work within the budget. This approach encourages organisations to search for ways to keep costs low. It helps to make operations lean and improves project planning. The total cost to the client is lower without sacrificing the project’s quality.
Risk-Sharing Mechanism
Cost risk is divided between the contractor and the client. The two parties are both responsible for some of the overruns. It creates an environment where people team up. The aim is to have each party interact and deal with risks before they become problems. Each business limits its own risks by choosing a certain contract structure.
Complexity in Negotiation
It is necessary to understand technical matters to set targets and share ratios. It can be difficult to find mutual agreement about ceiling prices and positive incentives. A mistake during these steps may lead to problems. When new partnerships are formed, it can be challenging to finalise the contract because of the involved terms.
Requires Precise Cost Estimation
Proper estimating of costs is extremely necessary. When estimates are incorrect, it can upset incentives and impact who deserves the profits. Good estimation methods are essential for contractors. They require dependable records from the past and predictions of future risks. A lack of this can lead to economic uncertainty for both sides.
