Why and when do companies need contracts in purchasing management?
What are the main contract types used by companies?
What are the advantages and risks of each contract type?
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In this lesson, we will be exploring 3 questions about contracts in purchasing management.
Why do companies need contracts? When is a contract is needed or not?
What are the most common contracts?
What are advantages and risk of each contract type?
How to choose the best contract type for the company’s needs?
Let's get started!
Why do companies need contracts?
Well, sometimes they need, sometimes they don't.
A contract is better when: the company needs a continuous supply,
of products with complex requirements,
of customized solution, with significant information sharing
for a medium/long term commercial relationship.
When a contract is not required:
in discrete or one-time purchasing
to fulfill an occasional short-term need
in a simple buyer-seller transaction
when there is no process integration
A contract is a good tool to define
what is being bought and its cost
operations processes for ordering, shipping, and receiving
to define quality and acceptance criteria
to establishes payment and warranty procedures
With contracts, companies manage
1) information flow: the contract
establishes the communication process
Who sends/receives information, at what time
in what form.
Also, how communication systems will be integrated,
what information will be transferred
through electronic data interfaces (EDI)
2) the goods flow: the contract defines defines
how materials will be ordered, how materials will be ordered,
transported, delivered, received, and accepted
3) In the Financial flow: contracts describe
how and when payments will be made.
4) commercial relationship,
contracts specify the point of contact
who is responsible for what
and the escalation procedure
in case of problems
What are the main contract types companies use?
There are 3 main contract types:
fixed price, time and materials, and cost based contracts
Almost all purchasing contracts are based on some form of pricing mechanism
and can be categorized as a variation of two main types:
fixed-price or cost-based
Fixed-price is a contract in which the price of the product or service is fixed
during the contract duration.
In this contracts, buyer and seller
should know very well the specifications
and therefore, the cost can be better estimated
In a cost-based contract, the buyer agrees
to reimburse the supplier for the expenses incurred
and, of course, plus a dollar amount of profit.
To protect against cost overruns,
some companies define the maximum cost
the supplier cannot exceed.
In Time & Material (T&M) contract,
cost unit rates are predetermined,
but the labour and material quantity can vary.
Therefore, the total cost is not fixed
although unit cost is predetermined.
It is a kind of hybrid contract.
In this small example, the brick and the labor rate have a fixed cost,
the total price will depend on the amount of the material used and hours worked.
Fixed-price contracts may have problems to handle changes and quality assurance.
There are small modifications that can be implemented
to reduce the most common risk.
The main varieties are intended to provide provide
formal mechanisms to change prices
and to provide incentives for quality.
The major challenge is cost-based contracts
is the risk of cost overrun.
Sometimes is nice to change some aspects
to motivate contractors to keep the costs low.
Financial incentives are usually very effective.
What are the advantages and risk each contract type?
Cost overrun
The risk that the cost exceeds the contract budget
estimated cost, or target value,
is much higher in cost-based
To mitigate the risk, the buyer should
put additional effort in the contract administration, expenses control,
maybe include saving incentives for the supplier.
Low quality in fixed-price contracts
the potential for low quality is higher
Because the price is fixed, the vendor/contractor may be forced to reduce costs
what may affect product/project quality. To mitigate this risk, the buyer should
have well know specifications
and include quality standards and expected performance in the contract.
Depending on the supply condition, one contract type may be
more suitable than the other.
For instance, every time that
there is a high level of uncertainty,
it is almost impossible to develop detail specifications.
therefore fixed-price contract is not recommended.
Long-term contracts also bring
changes naturally due to its duration.
Therefore fixed-price should be avoided.
In case the company has an in-depth knowledge
and experience about the product,
and are able to develop very well detailed specs,
fixed-price is a good alternative.
On the other hand, the cost-based contract
can be more suitable when there are
high uncertainty and long durations.
The Time and Materials contracts
are an intermediate solution that combines elements
of fixed-price and cost-based.
It has fixed-price for work-units and materials,
but also accommodate changes in the scope and workload.
In this video, we presented the main concepts of contract management.
To check your learning, try to answer the following questions?
Why and when do companies need contracts?
What are the main contract types used by companies?
What are the advantages and risks of each contract type?
What are the best scenarios to use fixed-price or cost based contract?
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