procurement-contracts

Today we will discuss procurement contracts in project management, types of procurement contracts, and procurement contracts examples.

Every organization needs procurement for growth and to achieve its objectives. Procurement, obtaining goods and services, is a requirement for businesses that want to survive and grow.

Whether projectized, functional, or matrix, every organization uses procurement contracts. Therefore, you must understand procurement regardless of whether you are a buyer or a seller. 

Before we dive into the types of procurement contracts, let us understand procurement and contract.

Procurement Contracts 

Let us understand the procurement.

Procurement

According to Wikipedia:

“Procurement is the acquisition of goods, services, or works from an external source. It is favorable that the goods, services, or works are appropriate and procured at the best cost to meet the purchaser’s needs in terms of quality and quantity, time, and location.”

Organizations require procurement for three reasons:

  • They do not have the expertise to complete a certain job.
  • They are busy with other responsibilities.
  • Procurement is sometimes cheaper than doing it yourself.

However, you must do a make-or-buy analysis before deciding on a procurement contract. Calculate the cost of doing this on your own and, through procurement, then select a cost-effective option.

If the benefits of outsourcing outweigh doing it yourself, outsource it.

For example, you must refurbish your office building, but you do not have the expertise for electrical work. You have two options to complete this task: do it yourself or have someone do it for you.

Since you do not have in-house expertise, the second choice will save you effort, money, and time. 

Contract

Now, let us understand the term “contract.”

A contract is a binding agreement between a buyer and a seller. It is key to the buyer and seller relationship and provides a framework to deal with each other.

Procurement contracts are also known as purchase contracts.

A procurement contract includes:

  • Product or service selection
  • Issuing RFI
  • Vendor selection
  • Issuing the RFQ/RFP
  • Bids evaluation
  • Awarding contracts
  • Receiving product or service
  • Making payment
  • Closing the contract

The Procurement Contract Process

The buyer starts the procurement process.

First, the buyer will collect the requirements and estimate the costs. Uses will provide the requirements and estimates from previous purchase orders. If this is a new order or service, the buyer will issue a request for information (RFI) to get the cost estimate.

After preparing requirements and estimates, the buyer will create the scope of work and raise the request for quotation (RFQ) or request for proposal (RFP).

Suppliers or contractors will submit their bids, and after bid closing dates, the seller will review all review offers and award the contract to the selected seller.

After receiving the contract, the seller will deliver the service or product on or before the delivery date mentioned in the contract terms and conditions.

The buyer will review the delivered service or product and release the payment. Once the seller receives the payment, the contract will end.

Contracts may have a guarantee clause. If this clause is there, the seller will provide the guarantee of the product until the specified period, and then the contract will close. 

What is Included in the Procurement Contracts?

A procurement contract can include the following:

Monitoring & Controlling: It ensures that the buyer receives the service or product as mentioned in the contract and that there are no deviations. In case of a deviation, the seller must correct it within the given period.

It also ensures the seller receives the payment after acceptance of the deliverable.

This element ensures both the buyer’s and sellers’ rights get protected.

Contract Closure/Termination: This includes terms and conditions for contract closure or termination. The contract will end after fulfilling the contract requirement or can terminate due to differences of opinion or other issues.

Alternative Dispute Resolution: The contract has a clause on how to solve a dispute. Both parties can opt for ADR in case of any dispute. They can approach the courts if the dispute is unable to be resolved through ADR.

Payment Terms and Conditions: This includes a description of how to pay the seller, whether through invoices or other methods. If it is a product or consumable, the payment can be onetime. However, if it is a service or construction contract, the payment can be regularly upon submission of the invoice as agreed in the contract.

Performance Bond: The contract must submit a performance bond, typically 10% of the contract value, until the guarantee expires. After the guarantee period, the contract can take back the performance bond. Sometimes performance bond is also known as a performance bank guarantee (PBG).

Types of Procurement Contact

types of procurement contract

A procurement contract can be of three types:

  1. Fixed-Price Contract
  2. Cost-Reimbursable Contract
  3. Time and Materials Contract

Fixed-Price Contract

Experts call a Fixed-Price contract a lump sum contract. You use this contract when there is a fixed scope of work. Once the contract has been signed, the seller is bound to complete the task within the agreed price and time. Therefore, the seller bears the most risk, and there is no price renegotiation unless the scope of work changes.

The below chart shows the risk in procurement contracts.

risk in procurement contract

Outsourcing and turnkey procurement contracts are Fixed-Price, and this contract is useful with a well-defined scope. 

Since the price cannot change, this contract is suitable for controlling costs.

With Fixed-Price contracts, scope changes are costly affairs. Contractors often get the contract by bidding the lowest price and then try to generate extra revenue at any opportunity, such as an added scope.

I have seen contractors quarrel with project managers regarding the scope. They argued on small issues to raise the change request.

Ensure a well-defined scope with complete details and monitor any changes in scope carefully.

You can divide a Fixed-Price contract into three categories:

  1. Firm Fixed-Price contract (FFP)
  2. Fixed-Price Incentive Fee contract (FPIF)
  3. Fixed-Price with Economic Price Adjustment Contract (FP-EPA)
Firm Fixed-Price Contract (FFP)

This is the simplest type of procurement contract. The seller must complete the job within a previously agreed-upon period. The seller is responsible for any increase in cost, and they are legally bound to complete the task within the agreement.

A Firm Fixed-Price contract is mostly used in government or semi-government contracts, where the scope of work is defined in detail.

This contract is easy to float and evaluate on a cost basis, which is quick.

Since the seller bears the risk, the cost is higher. The seller and buyer may have disputes if the scope is unclear. Any deviation from the original scope can cost you.

Example: The seller must paint the whole building for 50,000 USD within 18 months.

Fixed-Price Incentive Fee Contract (FPIF)

Here, although there is a fixed price, the seller may receive an incentive if they perform well, and this incentive lowers the seller’s risk.

Both the incentive and project metrics are interdependent, such as cost, time, or technical performance.

Example: The contractor will receive an incentive of 10,000 USD if they achieve the first milestone on time.

Fixed-Price with Economic Price Adjustment Contracts (FP-EPA)

You use a Fixed-Price with Economic Price Adjustment Contract when the agreement is multiyear. This contract has a special provision that protects the seller from inflation.

Example: About 3% of the project’s cost will increase after a certain time based on the Consumer Price Index.

Cost-Reimbursable Contract

Experts call this contract a Cost-Disbursable contract

Here, the seller gets reimbursed for completed work plus a fee representing their profit. Often, sellers earn this fee if they meet or exceed the selected project objectives: completing the task earlier, saving costs, etc.

You use a Cost-Reimbursable contract when there is uncertainty in the scope or higher risk. In this procurement contract, the buyer has the risk as they pay for all costs. 

This contract provides better cost control when you do not have a well-defined scope.

Scope creep is an inherent drawback of a Cost-Reimbursable Contract when the requirements are unclear. The seller may try to increase the cost to increase the fee or reimbursement.

You can minimize this through proper monitoring or capping the profit. For example, the maximum profit is 10% of the total cost.

You can divide Cost-Reimbursable contracts into four categories:

  1. Cost-Plus Fixed Fee (CPFF)
  2. Cost-Plus Incentive Fee (CPIF)
  3. Cost-Plus Award Fee (CPAF)
  4. Cost-Plus Percentage of Cost (CPPC)
Cost-Plus Fixed Fee Contract (CPFF)

Here, the seller gets paid for all incurred costs plus a fixed fee, regardless of their performance. The buyer bears the risk.

Organizations use this contract with high-risk projects where bidders are not interested in competing. 

CPFF contracts keep the seller safe from risks.

Example: Total cost plus 25,000 USD as a fee.

Cost-Plus Incentive Fee Contract (CPIF)

In a Cost-Plus Incentive Fee contract, the seller will get reimbursed for all costs plus an incentive fee based upon achieving certain performance objectives mentioned in the contract. This incentive is calculated using an agreed-upon formula.

Here, the risk lies with the buyer; however, it is lower than in the Cost-Plus Fixed Fee.

In a CPIF contract, the incentive is a motivating factor for the seller. 

An incentive is a percentage of the savings that buyer and seller share.

Example: The seller will receive 25% of the savings if the project completes under budget.

Cost-Plus Award Fee (CPAF)

Here, the seller gets paid for their costs plus an award fee. This extra will be based on achieving satisfaction according to specified performance objectives described in the contract.

There is a difference between an incentive fee and an award fee. An incentive fee is based on a formula defined in the contract and is an objective evaluation. An award fee depends on the client’s satisfaction and subjective evaluation. An award fee is not subject to an appeal.

Example: If the seller completes the task by meeting or exceeding quality standards based on their performance, the buyer may give an award of up to 10,000 USD.

Cost Plus Percentage of Cost (CPPC)

Here, the sellers are paid for all costs incurred plus a percentage of these costs. Buyers often do not prefer this type of contract because the seller might artificially increase the costs to earn a higher profit.

Example: Total cost plus 15% of the cost as a fee to the contractor.

Time and Materials Contract

This is a hybrid of Fixed-Price and Cost-Reimbursable contracts. Here, both parties share the risk.

You use a Time and Materials contract when the deliverable is “labor hours.” 

Here, the project manager will state the required qualifications and experience to the seller to provide the staff.

This contract guides the hiring of experts or outside support.

The buyer can specify the hourly rate with a “not-to-exceed” limit in this procurement contract.

Example: You will pay a technician 20 USD per hour.

Purchase Order (PO)

When buying commodities, purchase orders are used.

Example: Buying 10,000 bolts of cloth at the cost of 1.00 USD.

procurement contract table

Significance of Procurement Contracts

Businesses require products, sub-products, components, consumables, and services. They must buy products or services through suppliers or vendors. Procurement is a need of every business.

Businesses can outsource their requirement quickly and at a lower cost as suppliers get economies of scale benefits from their distributors or manufacturers. 

For example, if a company needs to buy electrical appliances, it can buy them from a supplier selling only the electrical supplier.

The supplier can deliver the material at lower prices because they only sell electrical appliances to all other businesses and have the benefits of economies of scale.

Benefits of Procurement Contract

Procurement makes business easier for organizations, allowing them to focus on their core business and outsource the rest. It helps companies share opportunities, hire experts, and buy goods or services.

Gone are the days when organizations oversaw and managed every single process that they needed in-house. These days, organizations perform their core functions and use procurement for other tasks.

In the early days, Ford Motors grew soy to extract oil for auto paint. Nowadays, no automaker does this. They buy paint and other components, such as tires or glass, from the market.

It is impractical to be involved in everything an organization needs. It is costly to get the right expertise and maintain it.

Procurement contracts are vital for modern businesses. It helps you find the best seller for your job with the right terms and conditions. You can select the right procurement contract per your requirements.

There are several types of procurement contracts, and you must understand each to select the one that fulfills your requirements. 

Summary

Selecting a procurement contract is an important part of a project, as it determines your relationship with the seller. You should select a contract that provides the best value for time and money and can protect your project from risks. 

Select a Fixed-Price contract if the scope of work is well-defined. However, Cost-Reimbursable is a desirable choice if there is no fixed scope of work. The Time and Materials type is appropriate for hiring consultants or outside support.

Fahad Usmani, PMP

I am Mohammad Fahad Usmani, B.E. PMP, PMI-RMP. I have been blogging on project management topics since 2011. To date, thousands of professionals have passed the PMP exam using my resources.