How to select the correct contract type that is most suitable for our requirement? Selecting correct contact form for a specific purchase agreement depends on various factors like availability and accuracy of pricing data, relative strength of buyer and seller and perceived risk and market competition.
Most of the contracts may be categorized either Fixed Contract, Cost Reimbursable contracts, Time and Material Contract, Indefinite delivery contracts or Service Agreements.
All these contract type can further be divided in many sub types depending upon their use, pricing structure and terms & conditions.
[1] Fixed price contract
It this contract type prices are set at certain amount and not subject to change unless buying organisation ask for change in specification, delivery or terms. For contracts of long period, high value, complexity of the performance increases, supplier risk rises in Fixed price contract. There are many variant of fixed price contract those are in specific scenarios to mitigate the risk.
Firm fixed price – from buyer standpoint, this is most preferred contract type because of minimum risk associated with buying firm. Supplier has to improve efficiency to hold cost down.
Fixed price with escalation – contracts with an adjustment / escalation clause, for long contract period and large contract value where there are higher chances for rate change due to inflation or deflation. Adjustment or escalation clause generally ties with recognized indices. Most appropriate for situation where market prices fluctuate like energy, metal or agriculture products. Another variant for this type of contract is Fixed price with downward price protection where prices can only be adjusted downward, gives maximum protection to buying organisation.
Fixed price with re-determination – used when moth quantity and price of material and labors are unknown. Generally, starts with temporary fixed price and later adjusted when all cost is known during the contract period. Most of the time re-determination are downward adjustment, and if upward then have some ceiling price negotiated.
Fixed price with incentive – give incentive to supplier for controlling cost with in certain target cost. Buyer share certain percentage of profit with supplier if target cost is met. Appropriate for high cost and long lead-time projects.
Fixed price level of efforts – prices are fixed per unit level of efforts, such as number of hours of testing at a fixed rate per hour. Typical applications are in R&D work, laboratory testing etc.
Fixed price with remedies – have an option of reimbursement of extraordinary cost incurred by supplier. A typical case may be when buying organisation ask for extended delivery date, supplier may be reimbursed for extra costs incurred.
The special challenges of project management under fixed-price contracts
[2] Cost reimbursable
This contract type permits payment of allowable, allocatable and reasonable cost permitted by contract. As the financial risk falls in buyer’s organisation, these types of contacts must be monitored closely. Common types of cost reimbursable contracts are –
Cost plus a fixed fee – allowable cost plus negotiated fixed fee
Cost plus percentage of cost – most undesirable as supplier has no incentive to control cost, higher cost means higher profit to supplier.
Cost plus award fee – if the supplier cost below target, supplier and buyer share profits. If the supplier cost is above target some portion of profit of supplier is reduced. Supplier can lose all its fee but not cost.
Cost without fee – reimbursement of cost and overhead, but no profit. Generally, happen between non-profit organisations.
Cost sharing – Buying organisation and supplier share the costs and benefits. e.g. supplier can develop an equipment for buyer and also use the equipment for other buying organisations.
[3] Indefinite delivery contracts
This contract type is used when buying organisation is not sure about schedule, quantity or frequency of the requirement.
Indefinite delivery / indefinite quantity – during a given period of time buying organisation with place its requirement with a supplier. Exact quantity or delivery dates are not known but minimum and maximum quantity is specified.
Task order and delivery order – a delivery order/ purchase order with reference to the delivery contract. Generally, Ts & Cs are not mentioned as they are described in original contract.
Requirements contract – used when purchase requirement are not known yet. minimum quantity is contracted and an expected range of requirement quantity is mentioned. e.g. contract for purchase of fuel for a fleet of vehicle.
[4] Time and material contract
This contract provides sale price of the material/parts plus labor and overhead cost at a certain per hour rate. Most automobile repairing contracts are time and material contract.
Letter contracts
This is a preliminary written contractual instrument, to kick off contract performance, usually followed by a definite contract document. Such letter should clearly mention limit of the Buying organisations liability in case whole contract doesn’t satisfactorily conclude and the important Ts & Cs of the purchase.
Blanket agreement
It’s a commitment to purchase goods or services over a specified time frame. It reduces administrative cost and frequent ordering cost.
Dealer’s agreement
Contract between a supplier and a dealer to grant the dealer right to purchase, sale or distribute suppliers merchandise.
[5] Service agreement
Used for contracting services such as maintenance, marketing, advertisement, janitorial etc.
Master service agreements – for maintenance of capital goods.
Professional service agreements – legal, accounting, auditing and other professional services.
maintenance agreements – preventive maintenance or repairing of machines.
Performance-based agreements – are those where outcome or timelines are specified in the service agreement.
Licensing agreements
They are used for buying licences like software, patents, technology, copyrights etc.
Master purchase or supply agreements
These contracts are often used for purchase of IT, hardware, desktop supplies like computers, equipment. MRO supplies etc. When needed Purchase Orders are placed with reference to the Master Contract. The specification, Ts & Cs are clearly mentioned in the contract and supplies are taken as per requirement.
Specialty Contracts
There are many specialty contracts which are used in specific purposes, like construction contracts in real estates, treaties and trade agreement between countries, contracts in government procurement etc. Other than project-based performance guideline, construction contracts generally specify clauses for safety, environmental impact, social responsibility, milestone payment, penalties etc.
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