Point of Total Assumption (Part 2): Most of us know the formula for Point of Total Assumption (PTA), but many don’t know what PTA actually means and how the formula is derived. In this article, we’ll demystify the secrets of PTA and in a follow-up article we’ll actually derive the formula from our understanding, rather than just cramming it up.
Point of Total Assumption in FPIF Contracts
PTA is used in Fixed Price Incentive Fee (FPIF) contracts. In a FPIF contract, the buyer and seller agree on a fixed price plus additional incentive fee for seller’s services. Fixed Price covers seller’s actual costs such as cost of raw material, labor and equipment. Incentive is the seller’s fee or the actual profit.
FPIF contracts are used less frequently than Firm Fixed Price (FFP) contracts, and are used with initial production lots where scope is well defined but cost history does not support a FFP contract.
Let’s consider an example. The project is estimated to cost $60,000. The seller (contractor) will get $15,000 as fee.
The buyer tells the seller, “The scope of this project is very clearly defined. However, I understand that such a project has not been done before and we do not have historical data to support your cost estimate. I acknowledge that there is a possibility of cost overrun on this project. So, I’m ready to share the extra cost with you to some extent. I’ll pay 60% of the cost if there’s a cost overrun and you’ll have to bear the remaining 40%. After all, I hired you for your competence and expect you to manage the project costs carefully. My total budget for this project, including your Incentive Fee is capped at $100,000 (Ceiling Price). So, no matter what happens on this project, I shall not shell out a penny more than $100,000.”
The seller knows that he/she has to watch the cost. Buyer has set a Ceiling Price. So, even if buyer shares 60% of the cost overrun in the beginning, there will be a certain point, at which the entire budget (Ceiling Price; $100,000) of the buyer will get consumed. When the buyer’s Ceiling Price is hit, buyer will stop bearing any additional cost on the project and seller will have to bear 100% of the additional cost beyond that point. This point is the Point of Total Assumption.
Is Point of Total Assumption also the Point of Zero Profit?
Point of Total Assumption does NOT mean Point of Zero Profit - now this is a point (no pun intended) that most people have difficulty understanding. Point of Total Assumption is the project cost beyond which buyer will not share the additional cost with the seller.
You can also say that at PTA, the share ratio ceases to operate. So, in our example, the share ratio will change from 60:40 (Buyer:Seller) to 0:100 (Buyer:Seller) at PTA.
I hope you understand the point behind Point of Total Assumption now. In the next article, we’ll work together to derive the formula for PTA. For now, with the understanding that you have gained so far, try to answer the questions posted here:
Point of Total Assumption - Test your Project Management knowledge
Phir Milenge (we’ll meet again) …
- Point of Total Assumption (PTA) - Introduction
- The Point behind Point of Total Assumption in FPIF Contracts (you are here)
- Derivation of Point of Total Assumption (PTA) Formula
- Point of Total Assumption (PTA) - Interesting Facts (PMP)
- Seller Fee Calculations in FPIF Contract
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