Types of Contracts in Procurement
For project managers and procurement professionals, utilizing the right type of procurement contract can have a substantial influence on the success of a contract. Given that there are different types of procurement contracts, each type has certain benefits and drawbacks.
Before we jump into exploring each type of procurement contract, let’s first understand what a procurement contract is.
A procurement contract is a contract that is utilized by the procurement teams in the enterprises to procure or purchase goods or services from the suppliers or vendors in exchange for payment.
For one product or service, there are a lot of options for businesses to choose from. So depending on the type of business and products or services they want to procure, the procurement process may vary in complexity.
The stakes of procurement contracts
In essence, procurement contracts are typical agreements that take place between a buyer and seller (Vendor or supplier) by establishing legally binding terms and conditions of a transaction.
Some of the common elements of the contracts are:
- Who will bear additional liabilities or expenses?
- What will happen in case additional goods or services are needed?
- What will happen if either party does not respect the timeline or delivery milestone?
- What will happen in case of cost overruns due to either party?
- What will happen if the cost of the goods or services goes up during the project?
Types of procurement contracts
Knowing the nuances of each type of contract is essential as they all have their own set of advantages and disadvantages.
Procurement contracts create the framework for every project which is why it is crucial to utilize the right contract. Even a small mistake or error could cost the enterprise more money in the long run. Enterprises may have to spend more money or resources in case they used the wrong type of contract. For example, instead of a fixed-price contract, if an enterprise uses a time and materials contract, the enterprise may end up incurring additional expenses as they have to take measures to make sure the other party (Vendor/supplier) stays compliant with the contract terms.
Let’s take an in-depth and closer look at the most commonly utilized procurement contracts and when to use them.
- Fixed-price contracts
This contract can be used when the procurement team or enterprise knows exactly what the scope of work is. Otherwise known as lump sum contracts, fixed-price contracts are an effective way to get the work done at a low cost when the scope of the work is predictable. For instance, if an organization needs specific goods or services from a supplier and the scope is mentioned as it is, the contract will make sure that the organization pays a fixed price for the purchased material.
Upsides of fixed-price contracts:
→ The vendor/supplier should deliver the goods or services as discussed within the specified timeline after both parties have signed the contract.
→ As it is a fixed-price contract, it would be easier for both parties to maintain price control.
→ As the vendor/supplier is now legally obligated as per the contract, he/she will bear the majority of the risk.
The fixed-price contracts story doesn’t end here. It can be further classified as below:
Fixed Firm Price (FFP)
In this category, both fixed price and time frame will be covered. The FFP contract mentions the project’s cost and timeline. For example, the contract will mention something like this “$200, at the end of the month.” If there is a mistake or error from the supplier side or something happened on the supplier side that caused the cost to rise, the enterprise will only pay the original price that was mentioned in the contract, @200, and the supplier will be held accountable for the difference amount. When the organizations have the scope of work in detail, then this is the ideal type of contract to go for.
Fixed Price Incentive Fee (FPIF)
FPIF is pretty much similar to the Fixed Firm Price contract. However, the only difference between FPIF and FFP is that there will be a monetary incentive for the supplier if he/she does a better job or finishes it ahead of schedule. Now, the exact monetary amount can be decided by the organization along with the conditions under which it will be paid. For instance, if the project is completed ahead of schedule or with excellent performance, the supplier will be paid $100 as a monetary incentive.
Fixed Price with Economic Price Adjustment (FP-EPA)
This type of contract is utilized when a project is estimated to take a long time so that the supplier can secure himself/herself from inflation during the course of the project. For instance, the FP-EPA contract lets a clause that gives the supplier a certain percentage rise after a decided amount of time.
- Cost Reimbursable Contracts
Also known as cost dispersible contracts, when the enterprise doesn’t exactly know the project scope or is likely to change later, cost reimbursable contracts are ideal. This type of contract’s purpose is to keep both budget and people on track. The difference between cost reimbursable contracts and other contracts is that the supplier will be compensated for the project’s cost once the job is finished, as well as earn a certain amount as profit. For instance, it can be based on how well the supplier meets the project’s objectives if the job is completed in time, and how well the supplier completed the project within the budget.
Cost reimbursable contracts can be further classified as below:
- Cost Plus Fixed Fee (CPFF)
This type of contract is ideal for enterprises when a project has high-risk and the procurement team is worried whether it will be able to attract the bidders or not. Since the risk is borne by the enterprise, suppliers will be protected by the CPFF contract. A particular clause in the contract mentions that the supplier will have to be compensated for all additional expenses, along with a fee that is not associated with cost performance.
- Cost Plus Incentive Fee (CPIF)
The enterprise takes all the risk in this kind of contract, but it is reduced as an incentive offer will be mentioned in the terms. The supplier will be compensated for these costs but can get a performance-based fee. Now, this amount is usually fixed and is a certain percentage of the amount saved by the enterprise because of the supplier’s excellent performance.
- Cost Plus Award Fee (CPAF)
In this contract, the compensation will be calculated based on to what level the enterprise believes that the supplier achieved the performance goals. As achieving goals is a subjective matter, the language used should be crystal clear. For example, it should be mentioned that the supplier will be compensated a specific amount of fee if the project requirements mentioned in the terms are met or exceeded.
- Cost Plus Percentage of Cost (CPPC)
This contract covers all of the supplier’s costs along with profit margin. There will be an incentive for suppliers to increase their actual costs to increase their profits.
Time and Material Contracts
This type of contract is mostly utilized when the supplier offers labor services. In such a scenario, both parties share a similar kind of risk. This contract mentions the expertise and qualifications needed when hiring outside suppliers. In their bid, the suppliers should submit hourly rates. It is essential to have a budget, otherwise, the project could go way beyond the budget.
Procurement is nothing but purchasing items or services. As much as private entities have the flexibility while procuring goods or services for their companies, government organizations don’t. They have to adhere to certain guidelines no matter what they are procuring. An efficient procurement system and the utilization of the right procurement contracts can have a direct influence on a company’s profits. Hence, it is imperative to understand and know which contract type best suits the company’s requirements and help achieve their goals within the budget while maintaining high-quality standards. To prevent paying additional costs or avoid any further disputes, both parties (Company and supplier) before entering into a procurement contract should make sure that all the necessary and essential clauses are in place and do not contradict their interests.