Fixed-Price and Cost-Reimbursement Contracts Comparison
There are two different types of contracts: fixed-price and cost-reimbursement. This essay is focused on the comparison of these two categories and what benefits and troubles can be caused by each to the small business. In a fixed-price contract, the contractor is paid the amount settled in the contract regardless of the actual costs of the project. In a cost-reimbursement contract, the contractor is paid all its allowed expenses to a set limit and an additional sum as profit.
The benefits of a fixed-price contract are the prospects for large profits. A scenario where the contractor works efficiently and is cost-sensitive will lead to a higher profit for the project. This type of contracting additionally creates an incentive for the contractor to minimize spending. However, this is a double-edged sword. On the one side, the contractor will strive to work as efficiently as possible, increasing the cost-benefit ratio. On the other side, it might lead to a decrease in the quality because the contractor is mostly concerned with the costs and not the quality of the finished venture. An additional downside with the fixed-price contract is that estimating costs can be quite challenging. Unfortunately for most companies, they tend to underestimate rather than overestimate their projected costs (Emmanuel, 2017). This can lead to massive economic losses for companies, where the costs vastly offset the revenue for the project.
In a cost-reimbursement contract, the benefit is that the company is secured a profit if the company does not overspend on the set limit agreed upon in the agreement. This leaves the company with less risk, but the company loses the possibility of increased profits. Thus, the incentive to reduce costs disappears. Therefore, the company will have less incentive to increase efficiency. On the positive side, the strive for cutting costs decreases, which removes the risk that it will influence the quality of the endeavor.
Small and Large Business Analysis
Usually, small businesses are presented as inferior to larger corporations because of benefits such as economies of scale, greater access to funding, and a larger base of human capital. Nevertheless, there are a few benefits to being a small business. The first benefit is rapid decision-making. Given that small businesses have smaller corporate structures, the period for decision-making is usually less compared to big businesses. This is because small businesses often only have one decision-maker, whilst larger corporations must consider a board, stockholders, the CEO, and different branch managers.
The ability for rapid decision-making gives the small business an additional advantage, namely flexibility. Since the decisions for change are made faster, small businesses can adapt to trends and exploit market opportunities quicker than large corporations. Small businesses also benefit from the entrepreneur’s financial incentives. The founder of a small business often benefits more from growing the company and increasing market capitalization. In the larger corporation, this incentive is often less evident since the company is owned by many shareholders.
Disadvantages of Cost-Reimbursement Contracts for the Small Business
As will be stated in the next part of the assignment, cost-reimbursement contracts are often beneficial for small businesses because they reduce the risk of the project and secures the firm’s profits. Even with these benefits, there are negatives related to the contracts for small businesses. Most small businesses are specialists, whilst large corporations are generalists. Therefore, small businesses often are more proficient than their larger competitors in their area of expertise. With a cost-reimbursement contract, the potential profit is much smaller than with a fixed-price contract. Therefore, the limited profit potential is the biggest concern with cost-reimbursement contracts.
The Most Beneficial Form of Contracting for the Small Business
For small businesses, forecasting costs on projects is often a challenge. There are two main reasons why small businesses find it difficult to forecast costs. The first reason is that the company has a limited portfolio of finished projects to compare with upcoming projects, making the forecasting of costs more challenging. The second explanation is that the companies often have a much smaller and less specialized cost center. With the lacking forecasting abilities, there is much risk associated with fixed-price contracts for small businesses. This is also partly due to the limited financial resources small firms must carry lemon projects, often leading to bankruptcy for the firm. Thus, small firms should strive to minimize risk in their contracts using either cost-reimbursable or time and material contracts.
The Most Significant Form of Contracting Supporting Large Companies
In comparison with small businesses, large companies have large portfolios of finished projects to compare with upcoming contracts. This experience and access to data allow the company to increase its forecasting abilities. In addition to this, the company has well-developed cost centers, often consisting of risk, procurement, and financial departments. Furthermore, the company has access to large amounts of capital from retained earnings. Another key aspect to consider with large corporations is that they have easier access to funding, both in the debt market and the capital market. This means that the company is less exposed to bankruptcy caused by lemon projects since the company is solid enough to withstand even large deficits from contracts.
This allows the larger corporations to be less risk-averse than their smaller counterparts, given the access and utilization of data and the greater financial solidity. Therefore, the optimal contracts for large corporations are fixed-price contracts since they more accurately can calculate potential profit for each of the contracts. It is important to note that large corporations also have a unique position to handle larger contracts due to their access to labor, machinery, and resources to bear the burden of high expenses today but receive a large lump sum in the future. Since most small businesses will not be able to do the same, the larger fixed-price contracts are often more accessible for larger corporations.
Plan of Awarding Company’s Contracting Form
The position of small businesses is at a disadvantage in these types of contracts. In a scenario to increase the Department of Homeland Security’s UAS surveillance, it requires large financial and human resources to research within this field. Nevertheless, a small business still has some beneficial points. As mentioned in the previous task, small business is faster and more flexible than larger corporations. Quicker decisions can be made, and leaders of small businesses tailor to exploit new opportunities and innovations in the field of UAS surveillance.
As a small business, this contract would probably be the largest and possibly the only contract we would be working with. This puts the company at an advantage compared to larger corporations, which handle several large contracts at a time. Thus, the company would primarily focus all its resources on this contract which can improve the quality of the results. Small business also has a stronger incentive to deliver a successful product in line with the contract. This is because of the explanations provided in task five, whilst large business has large access to capital, small business does not (Donald, 2020). Therefore, delivering a less than optimal product or having major additional costs occur could lead to the end of the company. Thus, small business has a stronger incentive to succeed than larger corporations.
Small businesses can also account for public opinion as a motivator for the government to provide this contract. With small businesses being the backbone of the American economy, there is always a good policy for any president seen helping them, as we also see with the current president Biden (Remarks by President Biden on helping small businesses, 2021). Hence, it will be beneficial for the government as seen helping small businesses and will work as an additional driver for granting small businesses contracts.
References
Donald, D. C. (2020). Smart precision finance for small business funding. European Business Organization Law Review, 21, 199-217. Web.
Emmanuel, A. A. (2017). Causes and effects of cost underestimation on construction projects in South Africa. Cape Peninsula University of Technology. Web.
Remarks by President Biden on helping small businesses. (2021). Web.