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COST PLUS INCENTIVE FEE CALCULATIONS FOR PMPEXAM

18Curtir Curtir

By Vinai Prakash

One of my PMChamp PMP Coaching Workshop students, Locksley asked me an interesting question

regarding contract calculations. Most questions in the PMP exam from the Procurement Management

Knowledge Area are about the different types of contracts, and choosing the best type of contract in a

particular situation. But this one was different…

This interesting Contract Question was however about calculations, requiring you to work out the total

payment due to the Contractor (Seller), in Cost Plus or Fixed Price type of contracts.

In this post, I’ll show you how to tackle this kind of contract calculation questions for the PMP exam.

First of all, you must know what is a CPIF contract – a Cost Plus Incentive Fee contract. In the CPIF

contract, the buyer contracts the seller to reimburse all the costs for the project.

But then, how does the seller make money?

Because only the Actual Cost is covered… So the Buyer agrees to pay an Incentive Fees to the Seller.

Thus the name of the contract – CPIF .

However, the seller should not take undue advantage of this situation, knowing that all costs are covered

(like having a blank cheque). Because the seller can become complacent, knowing that all costs are

covered, and that a profit (incentive) is guaranteed.

Therefore, the Buyer sets out clear guidelines for the incentives, and a profit sharing ratio. There is a good

chance of making a decent profit, and there is a penalty to finish the project later, or at a higher cost than

targeted.

This incentives the Seller to:

1. Keep the costs as low as possible,

2. Finish the contract as early as possible,

3. And generate the maximum incentive and profit.

Question: A cost-plus-incentive-fee contract has the following characteristics:

Sharing ratio: 80/20

Target cost: $100,000

Target fee: $12,000

Maximum fee: $14,000

Minimum fee: $9,000

How much will the seller be reimbursed if the cost of performing the work is $95,000?

A) $98,000 B) $100,000 C) $108,000 D) $114,000

Before we attempt this question, we need to understand the terms set in this question.

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Sharing Ratio

A CPIF contract has a Sharing Ratio. A 80/20 sharing ratio means that 80% is for the buyer, and 20% is for

the seller . Remember this. The ratio is always written in the Buyer:Seller Ratio format.

Target Cost

The expected cost, or the target cost of this project.

Target Fee

This is the expected fees that the seller will get. The seller is primarily working to get this fee in doing the

project. Plus there is the expectation of an incentive fee…

Maximum Fee

This is the maximum incentive the Seller can expect to get, based on good performance, and the sharing

ratio.

Minimum Fee

This is the minimum incentive fees the seller will get for meeting the requirements set in the contract.

Calculating the Final Incentive Fee

The final incentive fee due to the seller is calculated as:

Final Fee = ((Target cost – Actual Cost) * Seller’s sharing ratio) + Target fee

Substituting the values in the above formula, we get

Final Incentive Fee = (( $100,000 – $95,000) * 20% ) + $12,000

= $5,000 * 20% + $12,000

= $1,000 + $12,000

= $13,000

But this is just the incentive. The Seller will also get the costs paid .

Therefore, the Final Reimbursed Price = Actual cost + Final Incentive Fee

=$95,000 + $13,000

= $108,000

Therefore, the answer for this PMP question would be Choice C = $108,000.

Another variation of this questions is given below:

Question: Using the same data as above, what will be the reimbursement to the seller if

the cost of performing the work is $120,000?

A) $112,000 B) $119,000 C) $126,000 D) $129,000

Calculating the Final Incentive Fee

Do note here that the Actual cost is $120,000, and it is ABOVE the Target Cost. Thus, the seller has

exceeded the costs, and will be penalized.

The final incentive fee due to the seller is calculated as:

Final Fee = ((Target cost – Actual Cost) * Seller’s sharing ratio) + Target fee

Substituting the values in the above formula, we get

Final Incentive Fee = (( $100,000 – $120,000) * 20% ) + $12,000

= -$20,000 * 20% + $12,000

= -$4,000 + $12,000

= $8,000

This incentive is lower than the Minimum Fee. Thus, the $8,000 will be adjusted upwards to $9,000

(the minimum amount). The Seller will also get the costs paid.

Therefore, the Final Reimbursed Price = Actual cost + Final Incentive Fee

=$120,000 + $9,000

= $129,000

Therefore, the answer for this PMP question would be Choice D = $129,000.

EXAM TIP: Remember to adjust the Incentive to factor the Minimum Fee and the Maximum Fees. This is

precisely set in the first place, within the CPIF contract, so that the seller does not make an unduly high

profit. But is incentivised to make the most of it too!

Let me know if this makes sense. Do post a comment, and share your thoughts.

If you liked this post, do Like us on Facebook,

and spread the word among other PMP aspirants.

And if possible, do join the PMChamp Online

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All The Best!

Cheers,Vinai Prakash, PMP

Founder: PMChamp – Helping you prepare for the PMP Exam with Tips, Tricks, and Techniques.

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FILED UNDER: KNOWLEDGE AREAS, PMP EXAM TIPS, PMP FORMULA QUESTIONS, PROCUREMENT

MANAGEMENT

3 Comments 1

Chee Khang Ang

Dear Prakash

Thank you for the clear example and explanation which solved my doubt on the

different incentive contracts

SP

This is awesum. Thanks a lot. I have these concepts clear now.

Wajiha

makes perfect sense when you emphasize the adjustment rule which unfortunately I

forgot to do in the second question. Thanks for that reminder!

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