Today we will discuss procurement contracts in project management, types of procurement contracts, and their examples.
Every organization needs procurement for further growth, and they need outside help to achieve their objectives. Procurement, obtaining goods and services, is a requirement for businesses that want to survive and grow.
Before we dive into types of procurement contracts, let’s understand procurement and contract.
Let’s understand the 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 that they are procured at best possible cost to meet the needs of the purchaser in terms of quality and quantity, time, and location.”
Organizations require procurement for many reasons:
- They don’t 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 cost-benefit 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 don’t have the expertise for electrical work. You have two options to complete the project: do it yourself or have someone do it for you.
Since you don’t have in-house expertise, the second choice will save you effort, money, and time.
Now, let’s 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 it provides a framework to deal with each other.
Types of Procurement Contact
Any contract between two or more parties to deliver services or goods is a procurement contract. A procurement contract can be of three types:
- Fixed-Price Contract
- Cost-Reimbursable Contract
- Time and Materials Contract
Many experts call a Fixed-Price contract a lump sum contract. You use this contract when the scope of work is fixed. Once the contract is signed, the seller is contractually bound to complete the task within the agreed price and time. Therefore, the seller bears most of the risk, and there is no price renegotiation unless the scope of work changes.
Generally, outsourcing and turnkey procurement contracts are Fixed-Price, and this contract is useful with a well-defined scope.
Since the cost 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 agreed initially but later argued on small issues to raise the change request.
Ensure the scope is well defined with complete details; monitor any changes in scope carefully.
You can divide a Fixed-Price contract into three categories:
- Firm Fixed-Price contract (FFP)
- Fixed-Price Incentive Fee contract (FPIF)
- 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 time frame. 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 specific detail.
This contract is easy to float and receive bids, and it is evaluated on a cost basis, which is fairly quick.
Since the seller bears the risk, the cost is higher. If the scope is not clear, the seller and buyer may have disputes. Any deviation from the original scope can cost you a lot.
Example: The seller must paint the whole building for 50,000 USD within 18 months.
Fixed-Price Incentive Fee Contract (FPIF)
Here, although the price is fixed, the seller may receive an incentive if they perform well, and this incentive lowers the seller’s risk.
The incentive is tied with project metrics, 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.
Many experts call this contract a Cost-Disbursable contract.
Here, the seller is 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 you with better cost control when you don’t 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:
- Cost-Plus Fixed Fee (CPFF)
- Cost-Plus Incentive Fee (CPIF)
- Cost-Plus Award Fee (CPAF)
- Cost-Plus Percentage of Cost (CPPC)
Cost-Plus Fixed Fee Contract (CPFF)
Here, the seller is 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 be reimbursed for all costs plus an incentive fee based upon achieving certain performance objectives mentioned in the contract. This incentive will be 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.
Generally, an incentive is a percentage of the savings that buyer and seller share.
Example: If the project is completed under budget, the seller will receive 25% of the savings.
Cost-Plus Award Fee (CPAF)
Here, the seller is 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 calculated based on a formula defined in the contract and is an objective evaluation. An award fee depends on the client’s satisfaction and is evaluated subjectively. 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 seller is 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 is used to hire experts or outside support.
In this procurement contract, the buyer can specify the hourly rate with a “not-to-exceed” limit.
Example: You will pay a technician 20 USD per hour.
Purchase Order (PO)
This contract is used to buy commodities.
Example: Buying 10,000 bolts of cloth at the cost of 1.00 USD.
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 handled every process they needed in-house. These days, organizations perform their core functions and use procurement for other tasks.
In the early days, Ford Motors used to grow soy to extract oil to use in auto paint. Nowadays, no automaker does this. They buy from the market if they need paint and other components such as tires or glass.
It is impractical to be involved in everything an organization needs. It is costly to get the right expertise and then maintain it, and this may cause a substandard or over-priced product. In either case, it is bad for an organization.
Procurement management is vital for modern businesses. It helps you to find the best seller for your job with the right terms and conditions, and it lets you select the right procurement contract as per your requirements.
There are many types of procurement contracts, and you must understand each of them to select the one that fulfills your requirements.
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 good choice if the scope of work is not fixed. The Time and Materials type is appropriate for hiring consultants or outside support.
What kind of procurement contracts do you use in your projects? Please share your experiences in the comments section.