For procurement professionals and project managers, using the correct type of procurement contract has substantial impact on the success of a contract. Each type of procurement contract has certain benefits and drawbacks.
First of all, it’s crucial to know the different types of contracts in the procurement process and how to know when to use a given one. Let’s dig into this important business area.
Feel free to skip to the most relevant section or read the whole article:
- The Stakes of Procurement Contracts
- Fixed-Price Contracts
- Cost Reimbursable Contracts
- Time and Materials Orders
- Purchase Orders
- Conclusion & Free Resources
The Stakes of Procurement Contracts
Before we get started, what exactly is a procurement contract? Procurement contracts are agreements that protect buyers and sellers by establishing legally binding terms of a transaction.
Contracts create the framework for each particular project or bid. As a result, it is critical to use the correct contract for each project. Mistakes here 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
2) Needing to pay extra because of a more costly contract
One example is using a time and materials contract instead of a fixed price for the wrong project.
Below is a list of each type of procurement contract option that is common for procurement departments. Additionally, we will go over the optimum circumstances for using a given contract type.
Contract Type I: Fixed-Price Procurement Contracts
These types of procurement contracts are best used when an individual knows exactly what the scope of work is. A fixed-price 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, there is cost risk. 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:
- 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 is completed on time.
- 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 in the contract. This makes controlling cost much easier.
- The seller assumes most of the risk because he has legally committed to project specifications.
This type of contract is best for outsourcing or turnkey projects.
Fixed-Price Contract Subtypes
Within fixed-price contracts, there are three further subtypes. Again, each one is ideally suited for specific scenarios.
Here’s a brief overview of each one.
- 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 works when the scope of the work is outlined in meticulous detail. That’s 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.
- The Fixed-Price Incentive Fee Contract (FPIF). This type of contract includes everything the FFP contract does. However, it adds a monetary incentive for the seller to do an even better job, or stay ahead of schedule. For instance, the contract includes 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.
- 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. This is 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 using fixed-priced contracts:
- 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. This is especially true if 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.
- Some contractors may submit a low bid in order to be awarded the contract, and then add scope 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. These are 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 great for keeping on schedule and budget.
The basic premise of the contract is that the seller is reimbursed for cost when his work is completed. Furthermore, they 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. Further, it could encompass how close to the timeline they complete the job. Finally, how well the contractor is able to stay at or under budget may matter.
With cost reimbursement contracts, 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 procurement contract.
The four that businesses typically choose from are:
- Cost Plus Fixed Fee Contract (CPFF). If the project is 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 them. The contract should include a clause that pays the seller for the costs they incur. It should also include a fee that is not based on this performance. For example, the contractor will be paid his costs, plus a $10,000 fee.
- Cost Plus Incentive Fee Contract (CPIF). In this type of contract, the procuring organization will also assume the risk. Fortunately, 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. Incentive fees are a predetermined percentage of the savings arising from the seller’s performance. This fee is usually split between the buyer and seller.
- Cost Plus Award Fee (CPAF). While the incentive fee is based on a predetermined percentage of savings, an award is different. Awards are subjective and 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 specific language. It should state the seller may be given an award of up to a dollar amount if they meet or exceed requirements stipulated in the contract.
- 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 best when the seller is offering labor and there is evenly distributed risk. This type of contract is typically used to hire an expert or other outside vendors.
What is one of the most common documents in the procurement department? Purchase orders are used for organizations to define their relationship with sellers. Therefore, they act much like a procurement contract.
When a company wishes to request an order for goods or services, they send a purchase order to sellers. Next, let’s look at the different parts of a purchase order.
Purchase Order Basics
The form includes the item type, number of items, and a mutually agreed price. As with fixed price procurement contracts, the more specific a purchase order can be, the better. Further, 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 language to communicate with the seller.
Doing so may present more work up front. However, 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.
Helpful Tools for Your Procurement Contract
Selecting the appropriate contract form will help ensure your company’s next project has the best chance of success, 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 you choose the right type of contract for a given job, it will likely still need to be negotiated, 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.
Conclusion & Additional Resources
Hopefully now you understand the different types of procurement contracts and how to mitigate your risk when forming them. This process is never ending, but with a solid framework and good tools, you can strengthen this area of your business each year.
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