A contract is required if you manage a project that involves contractors or vendors. In the PMBOK(r), there are two types of incentive fees contracts: Fixed Price Incentive Fee and Cost Plus Incentive Fee. If the seller meets certain performance criteria (usually cost-related), they will receive a bonus.
Here are some examples of performance criteria:
Complete a project less than $50,000
Product uptime is 99.99%
In 10 weeks, the project is complete
(Learn more about the different types of procurement contracts here.
(Read more about Automating Procurement.
This post will discuss the 7 formulas you need to calculate the incentive fees to FPIF and CPIF. Let’s first define the terms that you will need to be able to understand them.
Target Cost – The estimated cost of the project that the buyer and seller agree upon before work begins. This is the project’s budget.
Actual Cost – The project’s actual cost after it is completed. This is the sum total of all costs and fees paid to the seller.
Target Fee – A fee that is paid to the seller when the work is completed at Target Cost.
Cost Variance – The difference in cost between Target Cost and Actual Cost. Positive variance is good.
Share Ratio – The ratio of the cost variance between the buyer or seller.
Formula 1: Price = Cost + Charges
This is the basic formula used to calculate the price for FP contracts. Add the cost to the price and add a fee.
Formula 2: Cost Variance = Target cost – Actual cost
Cost variance is the difference between Target Cost (or Actual Cost) and Actual Cost. Positive variance is considered good. Negative variance is bad news for both the buyer as well as the seller.
Formula 3: Buyer’s share = Cost Variance * Buyer’s Share Ratio
In an incentive fee contract, the cost variance will be split between the buyer and seller. The contract will pre-determine the buyer’s share. The buyer’s share is the amount of extra savings or costs that the buyer incurs.
Formula 4: Seller’s share = Cost Variance * Seller’s Share Ratio
The seller’s share is the percentage of cost variance that will be paid to the seller or paid by him. Sellers will receive a bonus if their share is positive. If the seller’s share falls below their fees, the seller will receive less money. Before the project starts, the contract will determine the seller’s share.
Formula 5: Buyer’s share ratio + Seller’s share ratio = 1
The sum of the seller’s and buyer’s shares ratios equals 1.
Formula 6: Fee = Target fee + Seller’s share
The total amount paid to the seller is the Target Fee plus Seller’s Share. The Target Fee is predetermined and the Seller’s share is based on the seller’s ability to meet predetermined performance criteria.
Formula 7: Total Price = Actual Cost + Target Fee
The buyer pays the total project cost, which is the sum of the Target Fees and the Actual Cost.
Example of Incentive Fee
Let’s say you are the buyer. Your company gives you a budget to manage a development project. Your Target Cost is $400,000.
To solicit potential sellers, you post a Request for Proposals (RFP). After receiving 10 responses, you choose the most qualified candidate. Once you have selected the candidate, you negotiate and agree on a fixed price of $40,000 to complete the work and reimburse them for any expenses. The target fee is $40,000.
Let’s take a look at the price that you will pay, without any incentive fees.
Actual Cost Target FeeTotal price$360,000$40,000$400,000$400,000$40,000$440,000$440,000$40,000$480,000$500,000$40,000$540,000As you can see from the chart above, since the seller has no incentive to lower costs, you will li