Is a fixed price or performance-based contract suitable for any project?

A contract is either a verbal or written agreement between two parties (i.e. supplier and buyer) for the supply of goods and services in exchange for remuneration. Typically, projects are performed under legally enforceable contracts which document the terms and conditions that govern the behaviour of the parties. Contracts need to be tailored so they are appropriate for the ‘type’ of project undertaken.  Using the Cynefin framework, the majority of projects undertaken by industry can be grouped in to three types; simple, complicated and complex.

For instance, an example of a simple project is to deliver a fixed bridge consisting of 4 car lanes spanning a 2,000 meter gap utilising extant industry best practice knowledge and available resources.  In contrast, a complicated project could be delivering 4 identical ships where each ship is designed to carry 250,000 cubic meters of liquified natural gas.  The ship design will require knowledge of extant industry best practice as well as expert knowledge from various other domains.  However, complex projects may require integrating different technologies while applying both extant and emergent knowledge.

Simple projects, such as the bridge example above, can utilise a ‘fixed price’ contract to govern project deliverables and stakeholder behaviour.  The fundamental assumption underpinning this type of contract is that there will be no changes (i.e. fixed scope and schedule) as the project is delivered.  Unlike simple projects, both complicated and complex projects are more likely to have changes in scope meaning results may vary. For these types of projects, a ‘performance based’ contract is more suitable.

Evidence can be found to indicate that troubled procurement processes are often linked to poor understanding of project scope and incorrectly identifying its complexity.  For instance, it is common for a project initially considered simple and being delivered against a fixed price contract to be subject to many changes resulting in significantly higher costs while failing to meet buyer expectations.

Complicated projects may be considered to be merely simple resulting in an inappropriate procurement process and contract being applied. For example, a template from a standard suite of templates may be slightly modified to establish a fixed price, fixed schedule contract for a complicated project when cause and effect relationships are not clear. This example will probably result in the buyer paying a considerable premium for price certainty. 

Alternatively, a buyer noting intense competition in the market, may negotiate aggressively for a simple, fixed price contract where profit is minimal to a supplier.  In this high stakes ‘winner take all’ environment, a supplier may agree to participate and sign the contract for a project.  Later into the contract, the supplier may seek to vary the contract or lose interest quickly if the buyer changes its requirements which leads to high overhead costs related to managing related contract variations.  In an extreme case, a supplier may consider it more favourable to default on the contract rather than deliver the entire project. 

Conversely, categorising a complex project incorrectly as complicated may be even more damaging to project outcomes.  This could happen when the initial problem space analysis is rudimentary (i.e. expert advice is not obtained or is flawed) resulting in the entire procurement process being ‘under engineered’ and the contract being unsuitable for the project.

In conclusion, selecting a contract (i.e. fixed price or performance based) to deliver a project outcome should be considered after accurately assessing the project type. - Michael Kim