Practice Exams:

PMI PMP Project Management Professional – Introducing Project Procurement Management Part 2

  1. Planning for the Project Requirements

When we do procurement, we need to think about the project requirements. What are we purchasing and how does that satisfy our project requirements? So we’ll look at the project scope statement first. That defines the high level requirements and, well, it really defines exactly what we’re going to create the Project Scope Statement. The work breakdown structure in the WBS dictionary, though, gives us even more detail down to the work package level. So this helps us define what do we need to procure and what are we going to take care of internally in house. Then we have those documents, the Statement of Work in the Tor, the tour.

So the Statement of Work and the tour, they describe the work that’s going to be accomplished. It doesn’t define the whole product, it’s just what are we purchasing from the vendor. So the entire project could be procured from a vendor or a portion of the project. So whatever we’re buying, whether it’s the whole thing or just this portion of the project, that’s when we create the Statement of Work or the tour, the terms of agreement or terms of reference to that portion of the project that we’re purchasing. So if we are doing a new network upgrade, we might need to buy cables, and we might want to hire an electrician to do the cabling and to punch down the cables or to create a WiFi or whatever the case may be. We hire someone to do that portion of the project. So we wouldn’t do a Statement of Work that describes the whole project.

It would only be that networking, that electrical piece, and then we reference the requirements, documentation for what exactly are we buying, what exactly has to be satisfied through this contract? A tour. Here some things about the tour. So it’s a little different term than a Statement of Work. It’s? What task will the contractor complete?

What are the standards they’re going to fulfill? What data will the vendor have to provide in order to be approved? What are all the data and services that are going to be provided by the contractor to the buyer throughout the project? And then when’s the initial submission and how long does it take to review that? So we spelled that out here in the tour. Okay, so that’s all still part of planning. So we’ve got our procurement management plan, our Sow or Tor. So now we’re ready to move forward and to start working on actually procuring. So I’ll see you in the next lecture.

  1. Determining the Contract Type

One of the key things you’ll need to know for your exam will be what contract type is most appropriate for your project and for a given scenario. So we’re going to walk through all the different contract types and the big picture of contracts and really the characteristics of a contract you’ll need to be familiar with. So really only really know these contract types. I guarantee you you’re going to have some questions on contracts on your exam. So all about contracts. It’s a formal agreement between a buyer and a seller. The US will back up contracts through the court system. Contracts state everything that has to be true in order to close out the contract. Any changes to the contract, they have to be formally approved, controlled and documented and signed off on. Your contract may have the terms of how you are allowed to change it. It may be an addendum or it may be up to X amount of dollars or what’s the process. So the contract can even define how changes to the contract are allowed or declined.

 Just because I have a contract doesn’t mean I have to accept the changes. I could say we don’t have time, we’ve got other commitments, can’t take it on. Or we could say let’s finish this contract and we’ll make a new contract for that change. Contracts can be used as risk mitigation. And we know this because we’re talking about which risk response transfer it. I know you all got that one right. Some contract legalities here. There are two big categories we’re going to look at with contracts. We have a fixed, fixed price or cost reimbursable. Fixed price means this is the amount you pay. Cost reimbursable means you’re going to pay the cost that the vendor has.

The seller has to perform the work in the contract and there’s usually a profit margin built into that. But that has more of a flex because if the vendor’s cost fluctuate because of waste or some other nuance, then you have to pay for that because the cost is the type of contract. You’re paying for the cost to do the work. So generally cost reimbursable are riskier for you. The buyer fixed price is fixed, you’re only going to pay this amount. And there’s a couple of different flavors. With both of those we’re going to look at a contract has an offer. So this is the work we offer to do for you. We both accept it, we have to agree to it. And then we get the consideration, we get the payment that I will offer to build your house in consideration of the $500,000 has to be for a legal purpose and it has to be executed by someone that has the capacity and authority to act on behalf of the organization. So if I’m just a project manager, I can’t be signing contracts. I need to give that to my manager or the contract department. Whoever really has the authority to make that deal between the parties.

A firm fixed price contract means I am the seller and you’re the buyer. And I say, I will deliver to you four tons of pea gravel and it’s going to cost $1,200 or whatever, but I give a firm price. You’re not going to pay more or less. It’s the deal. So the seller carries the risk of cost overruns. If I didn’t pay attention to how far away you are from where that peakravel is, how far I have to deliver it, and it’s going to cost me a lot of money and fuel that’s on me. So any cost overruns comes out of my end. So if I’m building a big deck on the back of your restaurant where people can go out and eat their lunch outside or whatever, and I say, I’ll do that for it’s going to cost $10,000. All right, we have a deal. And then I get out there and I start working. And my team is having waste. They’re cutting the wood to the wrong length or the wood got wet or damaged. You aren’t paying anymore.

We have a firm fixed price agreement. That’s the deal. It’s on me, the buyer, you, specifies what you’re purchasing from me. Our contract could have an addendum if you want to change it. So I’m building this deck for you. It’s $10,000. And you come out and say, hey, this looks really nice. How about you build some picnic tables too? Hey, we can do that, but that’s not part of our contract. So we’re going to have to do an addendum for that change or we might just make a whole new contract for these picnic tables. So the firm fixed price specifies exactly what you’re getting for exactly this amount. So we’re really clear on that. A similar one is a fixed price incentive fee.

What this one does is you say, joe, I want you to build this deck for me in the back of our restaurant here, but I need it done in like ten days because we have a big party that’s going to happen in ten days. If you get it done by then, I’ll give you a $2,000 bonus. So I have a fixed price and an incentive to get this all done in ten days. So now I have to do some work about being more efficient and keeping my team on top of things and making sure there’s not waste because I want to hit that deadline to get the bonus. The incentive fee. The incentive fee in that example was for schedule, but you might also say it’s for cost, which at a fixed price, it’s really cost doesn’t matter, but a technical performance. So you could say if you can make this throughput even faster or make it more reliable or make it more attractive or what you create is low in cost to support, then I’ll give you a bonus. There might be a price ceiling on that bonus. So a good example was in Indianapolis several years ago.

I lived in Indianapolis for a pretty good stretch. As some of you know, in Indianapolis, there was a big project downtown where all these interstates came together, all these highways came together. They called it the mega project. And they gave this construction company, I think it was $100,000 for every day they got done early. So the up to a million dollars, I think that’s what it was. It was something like that. But the up to is the ceiling. So if you got done early, for every day you were done early, you got a bonus about 100,000. So you could be up to ten days early is the max. If you got done twelve days early, you didn’t get 1. 2 million. They got 1 million or whatever the terms were, but it was something like that. Well, the company that was doing the project, they worked 24/7. They had lights out there. They had a crew out there at nighttime, daytime, all the time they were working on it.

So they had done the math of what would their labor be per day to get that $100,000 bonus. So it may not have been a pure million dollar bonus for them, but they spent a little bit more by crashing the project and fast tracking the project and working 24/7. That was less than the cost of that was less than a million dollars. So they improved their profit margin so that’s the idea of an incentive fee. The risk they had was if there was a mistake and it set them back on their schedule, it would begin eating into that bonus because they would be done fewer and fewer days less than what they had anticipated. So the seller carried the risk of cost overruns on a really big project that’s going to last for several years.

We might allow a fixed price with an economic price adjustment, an FPE. What this means is the price of materials if they fluctuate, like the cost of steel or the cost of inflation, any other external conditions that could affect the price unfairly for the vendor, then we would adjust that fixed price up or down. So it goes both ways. But we have to identify what will be the standard, how will we know how much deal costs. So some type of a marker that we would follow that that would kick in. If it went above X amount percent or below a percent, it would kick in. So this economic price adjustment is good for long term projects. A cost reimbursable generally bad for you, the seller.

Now, I’m going to be the buyer, okay? I’ll be the sleazy buyer over here. And I say that because cost reimbursable often seem like used car smells and I can really control what you pay as the seller and you’re the buyer. So this is anytime you have cost plus cost plus a fee or some other modifier. It’s okay to use this if the scope of work can’t be defined early. I know we want to hire you to build this deck, but we’re kind of making it up as we go. All right. It’s going to be kind of crazy. We want some different patterns and some different things in here. So all right, we’ll do that. But it’s going to be cost plus a fee to make these patterns out of wood or whatever it is as we go. High risk may exist in this type of a project where we do a cost reimbursable.

So if lots of risk happen, then you have to pay for those because there’s a lot of risk here. We’re not going to carry all of this. We have to share that risk. The buyer, you carry the risk of cost overruns. So if I have wasted wood and material, then you have to pay for that. It’s a cost plus or cost reimbursable, so you have to pay for that. A cost plus a fixed fee is where I say I’ll come build that deck for you. And it’s $5,000 plus the cost of the wood, all right? So you have to pay for all the materials. So I’ll get receipts and show you that I bought wood. The danger with this is that if my team wastes wood or gets wet or damaged or whatever, you have to buy more wood. So it’s a cost plus a fixed fee. You’re paying for that material. So it’s a little bit dangerous. The fee is constant.

That $5,000 fee is based on the scope. If you change the scope, if you want to add picnic tables or benches, that’s outside of our scope, so my fee could go up. So the materials and the fee is going to change because you’ve added more things to the scope. A really dangerous one. Here is a cost plus incentive fee. A cost plus incentive fee is $100,000 to build this warehouse for you or a barn, let’s say, for you. And in this construction, I’m going to give you a bonus if you get done early. So if I rush to get done and I have waste and so on, you have to keep buying the materials. But I’ll get a bonus if I get done early. So you carry some risk here that I’m going to rush and have waste. Haste makes waste. In larger projects. You might have an incentive sharing, and the split is typically 80 20. So here’s what’s happening here. I borrow money from the bank to buy an old warehouse, and we’re going to convert this warehouse to condos.

And I want to hire you to come in and do the construction of this. So I’m kind of the deal maker here, the broker. So I borrow the money, a few million dollars to make all this happen. You come in and are doing the work until you finish the project. I am just paying and paying and paying. I don’t have a return on investment till you’re done because I can’t sell these condos until you’re done or I can’t rent them out until you’re done. So an incentive sharing is where I tell you if you hit these dates, these milestones between now and completion or beat them, I’ll give you a bonus. So the idea here with this 80 20 split is we say this is what the work is worth for your labor and time to get here. But if you get done early, I’ll basically pay you 20% of what you would have had and so on and so on and so on.

And so I can give you basically a bonus by getting done early. So you aren’t having to pay for additional labor, but you’re doing it well, and you aren’t having waste and so on. So you being the business owner, the construction company, you aren’t paying for labor, but you’re getting paid 20%, a nice little bonus as if you had paid for labor. So it’s a cost savings for both of us that we share. The 80% idea is you’re getting 20% of what you would have paid. And I have 80% because I didn’t have to pay it. For you. It’s good because you don’t have the overhead, the labor. For me, it’s good because you’re getting them faster or hitting your dates. So it’s an incentive sharing. It’s like a cost savings or a split. The contract will define what that split is like. That 80 20. You don’t have to say 80 20. You could say that the split is X amount of dollars. You could just say you get an early you get a little bonus here on these dates, so don’t get hung up on that 80 20 or incentive sharing.

It’s just a way of setting some markers. You hit these dates, you’re going to get a bonus for hitting these milestones. Now, one of the most unusual types of contracts is a cost plus award fee. You want me to build this deck for you? Okay. And it’s going to be $10,000. So I build the deck and I get done, and you like it. And I didn’t go over on cost. It’s really good. Materials are, you know, everything is $10,000. You inspect it and you say, great, Joe, it’s really good. I’m going to give you a bonus of one $500. That’s the award fee. So a cost plus award fee is a mysterious award that will be determined by you given to me, the seller. So the buyer determines what the fee is.

It could be whatever they want. They could say, here’s a dollar, that’s your award. The contract really doesn’t specify what the award fee has to be. So the award is determined by the buyer based on my performance. A time and materials contract is a very simple contract. Basically, it says, we’ll pay for your time, and we’re going to pay for your materials. So we could say up to 300 hours and up to $5,000. So we have a not to exceed clause.

So the seller, me, you’re going to give me an hourly rate and any materials that I buy, I’m going to give you a receipt, and you’re going to reimburse me for the cost. That’s time and materials, it can’t have a time limit as well. That this this contract is good for six months. So that’s a time of materials. You’re paying for time, and you’re paying for the materials. Know those contract types and characteristics, be able to recognize them for your exam.

  1. Determining to Make or Buy

In a project, there’s lots of reasons why you’re going to buy something or build something. Sometimes it’s more effective to hire a vendor than to take it on. Inhouse other times, you have more important things to do than some of these low level activities. So you farm it out. So, let’s look at reasons to buy or build. Then I’m going to show you a little formula that you’ll need to know when it comes to determining price should you buy or build. First off, why would I buy or build? It’s less costly. Could be cheaper to hire a vendor. Might be cheaper to do it in house. You have people that are available. So you use in house skills. You control the work by doing the work in house.

Also by creating it in house, you control the intellectual property opportunity to learn a new skill available staff that could be for you or the vendor. The vendor said, hey, we have people ready to work and we’ll give you a reduced rate. So they’re just looking to COVID their cost. And it also lets your team by giving stuff to a vendor, then your team can focus on more important activities or focus on the core project work. So, those are all reasons why you might buy and why you might build. Sometimes you have to make a determination should I buy something or should I build it? So, here’s the scenario. You know, your team can build it for $65,000. Once it’s built, it will cost $8,500 to support. Every month a vendor comes to you and they say, you know, what we can build that for $52,000. You just have to sign a contract with us to let us support it for $10,500 a month.

So you’re like well upfront that’s a pretty good deal, it’s less out of pocket. But every month I’m paying a little bit more. So to make the determination of which is the best decision, you find the difference of your out of pocket expense so 65,000 -52,000 that’s the difference between the build versus buy. So that’s $13,000. Then you find the difference of your monthly fee. Again, it would be 10,500 -8500 or $2,000 so the difference. There you divide by the difference of your out of pocket so 13,000 divided by 2000 is 6. 5. What that tells you is that six and a half months from now, you could have built it in house and only paid 8500 a month as opposed to $10,500. So, if your solution will be kept longer than six and a half months, it’s better to go ahead and build it yourself.

If it will be kept less than six and a half months, let the vendor do it. It’s a better deal for you. So that’s a buy versus build. Let’s do an example here together. If you want it, you can pause this and try it on your own and then come back. Or we can walk through it together right now. So if you want to pause it, you can. If not, here we go. Your team can create a solution for a solution for $245,600, and it will cost you $23,500 per month to support it. A vendor says their solution is only $12,000, but you have to sign a contract and pay them $49,000 a month.

Okay, so which would be a better solution yours or the vendors? So, if we drop in the facts here to build it is $245,000. To buy is only 12,000. That’s a difference of $233,600. Your monthly fee is 23. Five. The vendor’s fee is $49. So what’s the difference of $25,500 every month? You divide the monthly into your out of pocket expense, and you’ll see that in 9. 1 months, it would be better to build it than to buy it. So if you’re going to keep this longer than 9. 1 months, go ahead and build it less than 9. 1 months. It’s a better deal with the vendor. So you might have to do that on your exam.

So be aware of aware of that on your exam. Know how to do that. Make up some practice ones. A question I get a lot is, well, what if the monthly fee is also less than your monthly fee? That’s a great deal. It’ll never catch up. So be aware of that for your exam. Generally, the monthly fee is going to be more than your monthly fee. All right, keep moving forward. I’ll see you in the next lecture.

  1. Creating Procurement Management Plan

The procurement management plan has a lot of information in it. It really defines how we’re going to do the procurement processes, how we’ll do contracting, how we’ll choose a vendor and so on. So there is some coordination that happens that needs to be defined in the procurement management plan between the buyer and the seller or between the seller and the project team. So what about project activities? If one of the vendors is going to be a team member, how do they act, how do they report, what about their scheduling? So they need to have a resource calendar, so some scheduling here and then business operations.

They have to behave as if they were a regular team member, even though they’re a contract based. They needed to be as if they were a team member. Also the procurement management plan will define how will vendors be selected and what types of contracts are you allowed to use. The procurement management plan will also define independent estimates or should cost estimates. So here’s the deal. In a should cost estimate, it is where we have a project to do. Like we’re going to run new network cable through the whole building. So we hire an electrician to come out and take all the measurements to look, to see what we need and to create an estimate of what it would be and we pay them for their time. That estimate that that electrician created becomes the mean that we compare all other bids against. So it’s a should cost estimate. So when I receive a bid from a vendor to do that and they’re way off, like 50% off, then they didn’t understand it or maybe they don’t want to do the work, but there’s some reason why it was not close to our mean here.

They didn’t understand what the work is or who knows why. But a should cost means that this is what it should cost and the closest one to it that will be the one that we hire to do the rest of the project. A should cost or independent estimate could also come from historical information. So you had a similar project and this is how much it cost in the past from the vendor. So that’s what it should cost approximately. For our current project, you might have to work with a procurement office or a centralized contracting where they take care of all the procurement, thankfully. But for your exam, you’ll still need to know these processes and activities, what’s the lead time for procurement and then what’s the requirement of your contract for performance bonds or insurance? So often the contract will see you have to show proof of insurance like errors or omissions or liabilities or some type of performance bonds that you don’t wreck the project as the seller.

The procurement management plan will also define what forms and contracts we have to use and we’ll talk about these forms coming up. Although some of this may be enterprise environmental factors. You have a specific form that you fill out to start the procurement process. If you’re going to be working with multiple vendors, how will you manage that and all the interaction between the vendors, what metrics will you use for vendor selection? So you might have a screening system like you have to have a PMP on staff, you have to have a Ccissp or a professional engineer or licensed in your state or who knows, whatever you want. But those are screening systems.

So how will you choose? What metrics will be there to choose which vendor you will select from? Again, vendor certificates, insurance, bonds, licensing? What risk mitigation and liabilities do you have to consider in document in your procurement management plan for contracting? And then always you have enterprise environmental factors. So when you put things up to bid, your organization may have rules and policies, even regulations that you have to follow when it comes to opening up projects for bid and choosing vendors.

The procurement management plan will also define the roles and responsibilities for the project team and then for the project manager and the procurement office. So everyone knows what they’re responsible for as you enter into this contractual relationship. I’ve mentioned a couple of times the legal jurisdiction Austin contracts will say that if there’s a disagreement or a claim or a dispute, it’ll be settled in the county of Madison, in the state of Indiana or whatever vendor payment and currency. So is it net 30, net ten, yet international project? Is it US dollars or euro or whatever currency you specify in the contract? And then also what constraints, assumptions, what’s your risk management approach, and then do you have pre qualified sellers? All of that is also defined in the procurement management plan.