For procurement professionals and project managers, using the correct type of procurement contract can have a substantial impact on the success of a given contract. Each type of procurement contract has certain benefits and drawbacks.
In order for project managers and procurement specialists to secure the most advantageous outcome, it’s crucial to know the different types of contracts used in the procurement process and how to know when to use a given one.
The Stakes of Procurement Contracts
Contracts create the framework for each particular project or bid, and as a result, it is critical to use the correct contract for each project. If a mistake is made here, it could cost the company more money in the long run. Additional expenses and liabilities can occur from 1) having to spend extra resources getting the other party to comply, or 2) needing to pay extra because a contract that ends up costing more was used, for example, a time and materials contract instead of a fixed price for the wrong project.
Below is a list of each type of procurement contract options that are commonly used for procurement departments, and the optimum circumstances for using a given contract type.
Contract Type I: Fixed Price Contracts
These types of contracts are best used when an individual knows exactly what the scope of work is. A fixed priced contract, also called a lump sum contract, is ideal for keeping costs low when the project scope is predictable. For example, if a company requires services from a vendor and the scope of work is clearly defined, this contract ensures the company will pay only a specified amount of money for the work required. Here are some other benefits to using this type of contract:
o Once both parties have signed the contract, the seller is required to perform the service within the stated timeframe. This will go a long way in ensuring your project be successfully completed on time.
o It takes away the guesswork about price. For instance, if you hire a contractor to complete a project on a fixed price contract, they are required to do the work for the amount stated in the contract. This makes controlling the cost of a project much easier.
o The seller assumes most of the risk because he has legally committed to project specifications.
This type of contract is best suited for outsourcing or turnkey projects.
Fixed Price Contract Subtypes
Within fixed price contracts, there are three further subtypes, and again, each one is ideally suited for specific scenarios. Here’s a brief overview of each one.
o The Firm Fixed Price Contract (FFP). This is simplest of all the fixed price contracts. The selling price or fee is fixed , as is the timeframe. For example, the contract may state that the seller must complete the job for the price of $10,000 by the end of the month. If the seller makes a mistake or does something to cause an increase in cost, he will be responsible for it and the price will remain at $10,000. This type of contract should be used when the scope of the work is outlined in meticulous detail, which is why government offices often prefer to use it. This is the easiest type of contract for procurement professionals to use because it makes it straightforward to take bids and evaluate them together.
o The Fixed Price Incentive Fee Contract (FPIF). This type of contract includes everything the FFP contract does, but it adds a monetary incentive for the seller to do an even better job, or stay ahead of schedule. For instance, the contract can include a financial incentive if the seller finishes the job on time or early, at or below the bid price, or performs in an exemplary manner. This type of contract is well suited to providing the incentive necessary to ensuring the project is done on time and at or below cost.
o Fixed Price with Economic Price Adjustment Contracts (FP-EPA). This is the type of contract to use if the project is expected to last a long period of time because it protects the seller from inflation. For example, businesses can include a clause that gives the contractor a specific percentage increase after a predetermined period of time. Many organizations base this percentage on the Consumer Price Index.
Possible Issues with a Fixed Price Contract
Despite all of the benefits of a fixed price contract, there are some downsides that businesses need to take into account. Here are a few things to consider when considering using this fixed priced contracts:
o The scope of work must be perfectly defined when the contract is signed. If the scope is left ambiguous in any way, the seller can attempt to ask for more money it is perceived that scope has changed in any way. These types of oversights can easily cause a project to go over budget and should be watched out for.
o Some contractors may submit a low bid in order to be awarded the contract, and then add scope to the project in order to raise the price. Avoid this by paying close attention to any changes made by the contractor to the scope of the project.
Contract Type II: Cost Reimbursable Contracts
Another frequently used contract type is the cost reimbursable contract, which is also known as the cost disbursable contract. If the scope of a project is uncertain or likely to change, this type of contract can be best used for keeping everyone on schedule and under budget. The basic premise of the contract is that the seller will be reimbursed for cost when his work is completed, and also earn a fee for their profit. Businesses will have some flexibility in the contract in regards to establishing the “fee” portion of the contract. For example, the fee can be based on how well the seller meets or exceeds the objectives of the project, how close to the timeline they complete the job, or how much well the contractor is able to stay at or under the project budget.
With cost reimbursement contracts, unless the requirements are laid out in exacting detail, sellers may try to account for scope creep as a way to anticipate the elevating costs. One potential method to avoid scope creep is to cap the potential fee given to the contractor.
Four Types of Cost Reimbursable Contracts Subtypes
As with the fixed price contract, there are variations for a Reimbursable contract. The four that businesses typically choose from are:
o Cost Plus Fixed Fee Contract (CPFF). If the project is considered high risk and there are fears that the procuring organization will not be able to attract bidders, this type of contract is an ideal choice. With it, the seller is protected from risks because the procuring organization will carry all of them. The contract should include a clause that pays the seller for the costs they incur, plus a fee that is not based on this performance. For example, the contractor will be paid his costs, plus a $10,000 fee.
o Cost Pus Incentive Fee Contract (CPIF). In this type of contract, the procuring organization will also assume the risk, but that risk will be lower because the contractor will have an added incentive. The contractor will be reimbursed for their costs, plus an incentive fee that is based on the job performance. The incentive fee is typically a predetermined percentage of the savings arising from the seller’s performance and is usually split between the buyer and seller.
o Cost Plus Award Fee (CPAF). While the incentive fee is based on a predetermined percentage of savings, an award is subjective and is based on how well the buyer thinks the seller met his performance objectives. Since the award is subjective, it is not open to appeal. When creating the contract, use language that states the seller may be given an award of up to a dollar amount if they meet or exceed job requirements stipulated in the contract terms.
o Cost Plus Percentage of Cost (CPPC). A CPPC contract pays the seller all costs, plus a percentage of those costs as an added profit. Be careful with this type of contract because it provides an incentive for some sellers to inflate their costs in order to receive a bigger profit.
Time and Materials Contracts
The time and materials contract form is mostly used when the seller is offering labor, and the risk is evenly distributed to the buyer and seller. This type of contract is typically used to hire an expert or other outside vendors. In it, you will need to list the desired qualifications or experience, and the seller will submit an hourly rate as a bid. Be sure to set a limit or you could quickly find yourself over budget.
Purchase orders are perhaps one of the most common documents in the procurement department. Purchase orders are used for organizations to define their relationship with sellers and acts much like a contract.
When a company wishes to request an order for goods or services, they send a purchase order to sellers containing the request for the order. The form includes the item type, number of items, and a mutually agreed upon price. As with fixed price contracts, the more specific a purchase order can be, the better. Buyers should include exhaustive details in the document for more efficacious and beneficial purchase order.
When a seller, supplier, vendor, and so forth, accepts a purchase order it acts as a contract. They enter into a legally binding contract between themselves and the buyer. It is for this reason that the buyer should always use explicitly clear and specific language to communicate requests to the seller. Doing so may present more work up front, but it carries the added benefit of ensuring that there is no confusion when the purchase order is received and carried out.
An added benefit of purchase orders is that in the event the buyer were to refuse payment, the seller would be protected because the buyer is bound by the terms of the order to pay the agreed upon price.
Selecting the appropriate contract form will help ensure your company’s next project has the best chance of success has the best chance of finishing within the project’s budget, and serves overall company objectives while mitigating the risks and eliminating unneeded expenses.
Beyond selecting the right type of contract for a given job, drafting, negotiating, and executing those contracts well is a crucial process for success.
Even if the right type of contract is chosen and drafted for a given job, it will likely still need to be negotiated on, which can often turn into a laborious and tedious task. The aggravation associated with contract negotiations can be eliminated though through a cloud-based contract management platform.
Concord is a cloud-based contract management platform that’s changing the way the world is creating, negotiating, signing and managing contracts. With Concord, contracts can be stored online and negotiated on with vendors, contractors, third parties, etc. without ever having to leave the platform, leading to an easy and transparent process that ensures all parties are aware of terms, dates, and expectations without the usual headache that comes with collaboration and negotiation.
One of the primary benefits of Contract Lifecycle Management (CLM) software is that it makes collaboration simple and easy. A collaborative software program allows the entire team to access a contract draft in the cloud from wherever they are, make comments on specific portions of the document, and redline the document. Every member of the team will receive alerts when comments or changes are made, so everyone can stay informed. When you wish to integrate these changes into the document, it can be done easily online.
The platform is being used today by more than 40,000 companies in 130 countries, and tens of thousands of users who are now managing all of their contracts on Concord. Additional information can be found at http://www.concordnow.com/.