Procurement Contract Types : What You Need to Know

Introduction

I recently read that contracts have been instrumental in supporting the market economies of many ancient civilizations such as Rome, Mesopotamia, Egypt, and Greece, amongst others.
Since then, a contract has been seen as an enforceable commitment, bound by law. Today, businesses draft millions of contracts to protect themselves from any form of dispute. Organizations deal in some form of procurement of goods and services as part of their day-to-day activities, having a contractual commitment in place ensures that the interests of both the vendor and the company are legally protected. Irrespective of whether they are a small business or a large organization, contracts are an integral part of their operating environment. Having a procurement agreement also establishes a long-term relationship with vendors and uninterrupted continuity set with trust and confidence, thereby paving the road to business success. Therefore, companies need to implement and manage procurement contracts effectively.

In this article, we will discuss the value of procurement contracts, different types of procurement contracts, the symphony between contracts and procurement, and some details about the procurement contract process.

What is a procurement contract?

A procurement contract is a legal document binding a buyer and seller regarding the procurement of goods and services. Also known as a purchase contract, this type of agreement specifies details that the seller agrees to fulfil as per the buyer’s request. In turn, the buyer agrees to pay for the supplies as well as adhere to any other requirements made by the supplier. A procurement agreement outlines all the terms and conditions governing the relationship with the supplier concerning procurement.

Significance of procurement contracts

The above definition is a clear indicator of having a procurement agreement in place. It streamlines ordering, receiving goods, assessing invoices, and paying for supplies and services, preventing unnecessary conflict and safeguarding a business’s interest. But it is advantageous for a myriad of other reasons, such as:

1. Sustainable long-term partnerships:

it is true that having a procurement contract in place will protect both parties against any risk. More often, out of fear that one party will be held up by the other. However, when the contract terms are favorable for both the supplier and buyer, it can unlock significant new value with a lasting relationship. While the seller will ensure they pay special attention to uninterrupted quality production, timely delivery, and ethical working standards, the buyer will stress on timely payment of dues and adherence to other supplier requirements.

2. Better cost-saving opportunities:

When a contract specifies mutual goals and establishes governance structures to keep the parties’ expectations and interests aligned over the long term, suppliers become critical partners in lowering costs, maintaining quality, and driving innovation for a business. Massive cost-saving discounts such as delivery costs and volume discounts are leveraged to add value and competitive advantage to the organization.

3. Fosters trust and collaboration:

A legally enforceable contract benefits highly complex vendor buyer relationships in which it is impossible to predict every what-if scenario. Additionally, it identifies and mitigates the risks present with a vendor you want to get into business with during the contracting process, which bolsters transparency in the procurement process.

What is included in a procurement contract?

An ideal procurement contract holds the following information in detail:

• Performance and monitoring control to ensure that both parties benefit from the contract
• Receipt of supplied goods, their inspection parameters, and acceptance criteria to ensure that the provided goods meet the standardized requirements
• Contract termination details that outline the procedure to be followed when either party wishes to end the contract for business reasons
• Dispute resolution tactics when either party is dissatisfied with the relationship and wants to settle disputes instead of approaching the court
• Payment agreements and financial information with a detailed procedure for invoicing, payment, and other preferences
• Performance assurance information that both buyer and seller must comply with
• Contract completion details, along with a close-out option

What is a procurement contract process?

The purchasing contract or the procurement agreement process begins when a bid is confirmed, the supplier is sealed, and any form of negotiation is completed. Everything agreed upon is then written as an agreement.
The contract procurement method has its detailed process.

1. Establish contract requirements

The project manager or the procurement team is responsible for informing the contract manager about creating a contract with a specific vendor. They communicate what will be needed from the supplier, including materials, services, pricing, deadlines, technical specifications, and other requirements, with utmost clarity.

2. Drafting the contract

After understanding the scope and deliverables, the contract manager drafts the legal agreement. Some organizations have a ready-to-go template wherein confidentiality clauses, operational conditions, payment terms, legal compliance, risk management, contract termination, and additional details are already stated in detail. Only small additions related to the seller and procurement requirements are added. At the same time, some entities prefer to draft the whole document, which makes this step in the contract procurement process a bit lengthy.

3. Agreeing to the contractual terms by both parties

After drafting, the contract is sent to the procurement team for a thorough review and then to the seller. The seller sometimes adds their redlines if they don’t agree to the terms or need some modification to specifications and send the contract back to the buyer. If all terms and conditions listed are agreeable, the contract is sealed. This step is time-consuming and requires many resources.

4. Signing the procurement contract

Once a procurement contract is drafted, reviewed, negotiated, and approved, it’s ready to be signed by relevant stakeholders from both parties.

5. Adhering to the procurement agreement

Post signing, the seller gets to work and ensures they adhere to the agreed conditions. Meanwhile, the buyer constantly reviews the procurement contract to ensure all obligations are being met.

Different Types of Procurement Contracts

There are various types of contracts in supply chain management. The type of procurement contract that you choose depends on your business goals, risk tolerance, and vendor relationship. A risk management policy explains what is expected from both parties. Once the procurement contract is signed, both buyer and seller must adhere to the regulations.

Fixed price contract

The most straightforward type of contract is the fixed price contract, where buyers and sellers agree upon a fixed price for the supplies. The buyer must meet the minimum order quantity to invoke this type of contract. Essential supplies crucial to the supply chain are usually secured under a fixed-price contract that provides a cost benefit for the buyer. Both buyer and seller will get reasonable pricing, and the seller will get assured minimum order quantity.

There are three types of fixed-price contracts:

1. Firm Fixed Price (FFP)

The buyers and sellers have exact numbers on the agreement. The buyer will agree to purchase the minimum order quantity, and the seller will fix a reasonable price.

2. Fixed Price & Incentive Fee (FPIF)

FPIF contracts provide an advantage to the supplier because the buyer agrees to pay an incentive apart from the fixed price. The supplier will be incentivized if he meets and exceeds the contract terms. Buyers will get an assured volume of their orders, and suppliers will benefit from the incentive for offering the item at a discounted price. This contract is usually used for high-demand items, and the buyer is looking to lock the price.

3. Fixed Pricing with Economic Price Adjustment (FPEPA)

The FPEPA contract allows the seller to adjust the pricing if the production cost of the supplies varies. In this type of contract, a buyer and the seller will agree to a fixed price as long as the production cost remains the same. If the supplier proves that the production cost exceeded the agreed-upon value, they can increase the price. The contract helps the buyer lock in on an affordable price, and suppliers can protect their margins if they can justify increased production costs. Usually, FPEPA contracts are used to purchase a pre-built product that the supplier regularly wants. 

Cost Reimbursement Contract

When the buyer and seller enter into a cost-reimbursement contract, the buyer will reimburse the capital cost that the seller invested in a product or a service during the course of the project.

There are four different types of cost reimbursement contracts:

1. Cost Plus Fixed Fee (CPFP)

When the buyer and seller agree to the CPFP contract, the buyer provides terms and conditions for a product, service, or project expected from the seller. Quality and quantity requirements are mentioned clearly in the contract. The seller should deliver the product, service, or project satisfying the underlined conditions, and the seller is responsible for the total cost involved in the delivery. At the time of delivery, the buyer will inspect and verify the quality and quantity of the delivered product or service. If the delivered product is accepted, the buyer will reimburse the accrued production cost and pay an additional fixed fee for the seller, which is usually a percentage of the total cost. Suppose the delivered product is not of acceptable quality and violates the terms and conditions. In that case, the buyer can reject the delivery, and the seller has to bear the cost.

2. Cost Plus Incentive Fee (CPIF)

The CPIF model is similar to the CPFP model, where the seller and buyer agree to terms and conditions in terms of the quality and quantity of the product. The seller should take care of the expenses until product delivery. If the buyer accepts the product, the buyer will reimburse the total cost and pay an incentive for the seller. On the other hand, if the product doesn’t meet the quality standards, the buyer can reject the delivery, but in the CPIF model, both buyer and seller have to split the expenses of the unsuccessful project.

3. Cost Plus Award Fee (CPAF)

With a CPAF contract, the buyer agrees to reimburse the supplier’s cost and an award fee. The buyer determines this award fee.

4. Cost Plus Percentage Of Cost (CPPC)

With the CPPC contract, the buyer is responsible for reimbursing the total cost of the product along with a percentage of the cost that is usually considered a profit.

Time And Materials (T&M) Contracts

Under the T&M contract, the buyer will pay the seller for the time and materials invested in the project. Buyers can include a threshold that the time and material quoted can’t exceed. This is essential to get a fair price and also to prevent fraud.

Different types of contracts have their own pros and cons, and using the correct type of contract is the key to success. Your procurement solution will help you make the right choice.

Conclusion

It is safe to establish the fact that contract and procurement go hand-in-hand. It is reckless to indulge in procurement of any form without having a contract in place. According to a report by Gartner, by 2024, manual efforts for reviewing and drafting contracts will be reduced by 50 percent. An entire industry is shaping up to automate contracts and procurement, so much so that the contract management software and tools market is expected to be worth 12 billion dollars by 2025. As a business, you’ll lose value if you don’t mobilize this change, and automate your procurement contracts workflows. The right procurement software can streamline your procurement contract management process and secure more value for your organization.

About Procol

Procol is India’s fastest-growing procurement technology company and the highest-rated procurement software that has saved 15,000 hours by automating tedious procurement tasks for 100+ global enterprises. Its next-generation platform is known to get spends under control and ultimately gain 2-10% cost savings.

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