What is a fixed price contract?

A fixed price contract is a contract wherein a specified amount of money is promised in order to pay for the completion of a project or task. Fixed price contracts are commonly used in building/construction situations. The contract may either have a firm fixed price or, in certain cases, an adjustable fixed price where a maximum price and/or a target price are specified.

Understanding a Fixed Price Contract

A fixed price contract allows for the party contracting for a project or result to have a reasonable degree of certainty regarding how much it will cost to take the project to completion. For instance, a party may enter into a fixed price contract wherein a contract agrees to build a home for $200,000. The paying party will have confidence that the home will be completed for this amount of money.

Typically, careful specifications should be drawn out ahead of time specifying exactly what the paying party will get for his fixed price. Without these specifications, the contractor may have significant incentives to cut costs and may compromise on quality and materials. For instance, a contractor might use builder-grade, cheap and inexpensive materials to build the $200,000 house to maximize his profit, and the homeowner may end up paying far more than the home is worth.

In a firm fixed price contract, especially one with the specifications clearly established, the contractor takes on a significant risk. If the cost of materials rise, the contractor will still need to complete the project as specified for the cost that was agreed upon. This can eat into his profit and sometimes cause the contractor to lose money on the project. Fixed price contracts that adjust, on the other hand, may help to limit the risk for the contractor.

Types of Fixed Price Contracts

There are several different types of fixed price contracts that split the risk of cost increases differently among contractor/payer and result in the contractor being paid in different ways.

A firm fixed price contract has a set price that does not change. The contractor is responsible for paying all costs and assumes 100 percent responsibility and risk for cost overruns.

In a firm fixed price, level of effort term contract, the contractor is required to expend a certain amount of effort working on the project for a designated amount of time. This is often used when the government enters into research & development contracts.

A firm fixed price, materials reimbursement contract sets a fixed price provided for service. The paying party pays the actual costs of materials, reimbursing the contractor. This type of contract may be used in a repair situation. For instance, a car mechanic may provide a fixed labor price and the car owner would pay that price as well as the actual cost of materials. This puts the risk on the payer, who has to bear the burden of paying more when prices rise.

A firm fixed price with incentive contract provides a firm fixed price to be paid, but the contractor can earn a special incentive or added payment by fulfilling certain pre-defined objectives such as cutting costs or completing the project by a certain date.

In each of these situations, it is typically understood that the fixed price remains in effect only as long as the scope of work does not change. For instance, if a homeowner enters into a fixed price contract with a builder to construct a home and then the homeowner later decides that the home should be twice as large, the fixed price agreed to does not cover the expansion of the larger home. In such cases, in residential and commercial building environments, a change order is typically created wherein the scope of the work changes and the payer agrees to pay for the additional cost associated with the change.

Case Studies: Understanding Fixed Price Contracts

Case Study 1: Firm Fixed Price Contract in Construction

A homeowner, Mr. Smith, enters into a firm fixed price contract with a construction company to build a home for $200,000. The contract specifies the exact specifications, materials, and timeline for completion.

Both parties agree to the terms, and the construction company assumes full responsibility and risk for any cost overruns. The fixed price contract provides Mr. Smith with confidence that the home will be completed within the agreed budget.

Case Study 2: Firm Fixed Price, Level of Effort Term Contract

A government agency enters into a firm fixed price, level of effort term contract with a research and development firm. The contract requires the firm to dedicate a certain amount of effort over a designated period of time to a specific project.

The government agency pays a fixed price for the services rendered during the contract period. This type of contract is commonly used when the government engages in research and development projects.

Case Study 3: Firm Fixed Price, Materials Reimbursement Contract

This involves a car repair situation. A car owner, Ms. Johnson, takes her vehicle to a mechanic who offers a firm fixed price for labor and a materials reimbursement contract. The mechanic provides a fixed labor price for the repair, while the car owner is responsible for paying the actual costs of the materials used. This type of contract puts the risk of rising material costs on the car owner.

Case Study 4: Firm Fixed Price With Incentive Contract

A construction company enters into a firm fixed price contract with an incentive clause. The contract specifies a fixed price to be paid upon completion of the project. However, the contractor can earn a special incentive or additional payment by achieving certain pre-defined objectives, such as cutting costs or meeting the project deadline. This type of contract provides motivation for the contractor to excel and achieve the defined goals.

Getting Legal Help

Entering into a fixed price contract can be a wise choice when cost control is of the utmost importance. However, it is essential that the fixed price contract be as detailed and clear as possible to protect both the contractor performing the work and the party responsible for paying the costs. An experienced contract law attorney can assist in successfully drafting a fixed price contract that best protects the legal rights of all parties and should be consulted whenever a contract is drafted or signed.