Types of Contracts
Elaine M. Whittington, C.P.M.
Elaine M. Whittington, C.P.M., G & E Enterprises, Sunland, Ca. 90140, 818/352-4995.
79th Annual International Conference Proceedings - 1994 - Atlanta, GA
This paper will look at eleven contract types available to professional purchasing personnel. It will cover when the contract type might be used and discuss the distinct differences and peculiarities of each one.
The firm fixed price contract is used more often than any other type. Many buyers are uncomfortable with most any other type of contract. On occasion another type of contract can be used to better advantage for both the buyer and the supplier. This paper is meant only to explain what contract types are available in order that a good choice for each individual situation is made. The contracts will be discussed starting with the one over which the buyer has the most control and ending with the one which provides the least contractual protection.
FIRM FIXED TYPE CONTRACT
This contract type needs little explanation but should not be overlooked. Simply stated it is the type of contract used for items purchased which are easily defined and have established pricing when using a firm fixed contract the buyer agrees to pay a fixed price for a fixed quantity of goods (i.e. $1.00 each for 100 units). In this example the buyer is obligated to pay $100 once the goods are delivered and deemed to be correct and of acceptable quality. This type of contract provides the buyer with the most control of any of those which will be discussed but may not always be the best type to use.
FIXED PRICE ESCALATION CONTRACT
Fixed price escalation contracts are typically used when purchasing material which will be delivered over a period of several years. The agreed upon escalation clause will protect both the buyer and the supplier from material and labor fluctuations and can deal with cost decreases as well as increases. An escalation clause usually is an agreement that the contract will be adjusted once a year to reflect the difference in labor or material or some percentage of the unit price of each element. For example the buyer and the supplier agree upon labor and material indices as shown by certain economic indicators (i.e. labor could be those shown on the Bureau of Labor Statistics (BLS) Report) . Material fluctuations might be noted by current market costs on an agreed upon date or those published by some agency measuring such data. Additionally, the contract might note that 60% of the unit price would be adjusted for labor and 40% for material.
Agreements can vary from that discussed in the preceding paragraph to a simple statement noting that the contract will be adjusted 3% per year for its duration. The important concept to remember in using this type of contract is to be sure that the adjustment factors are fair and will allow both buyer and seller an opportunity for a reasonable contract arrangement. The adjustment clause must be clearly written and utilize appropriate indices. For instance if you are using labor indices for a machine shop contract the indices should reflect labor rates for machine shop personnel rather than labor rates for utility workers.
FIXED PRICE INCENTIVE CONTRACT
This type of contracting arrangement should be used for purchasing any item which is difficult to define or has never been produced in the past. It will protect the buyer from contracting at a very high price to cover any and all of the supplier's areas of uncertainty. It requires that the buyer and the supplier establish the following contract criteria:
- A maximum contract price.
- A target contract price.
- A fee.
- A sharing formula.
An example of a fixed price incentive contract could be as follows:
- Maximum price - $1100
- Target price - $900
- Fee - $90
- Sharing formula - 50/50
The supplier does not get any part of the fee until the costs fall below the maximum. Overruns and underruns of the target are shared per the sharing formula and added to or subtracted from the fee. Resulting payments for various cost results would be as shown below:
As you can see once the supplier can produce the item at a cost of $800 he will realize a profit of 17.5% and at $700 his profit becomes 27.5%. This provides a good incentive to become more efficient and control costs.
When utilizing this type of contract it is important that agreed upon costs are included as part of the contract negotiation. Also, the supplier must agree to demonstrate all costs with invoices and time cards as well as be able to allow validation of hourly wages paid and overhead calculations.
FIXED PRICE REDETERMINATION CONTRACT
This type of contract is used more often by government agencies than private industry. It is employed when the initial procurement of goods can be priced but due to material or labor fluctuation subsequent deliveries cannot be firm priced. It provides for negotiated upward or downward adjustments at stated times during the contract. A second type of contract usage allows the renegotiation to be done after contract completion. It's use is discouraged because the supplier might not control costs carefully when he will be allowed to demonstrate actuals "after the fact" and be reimbursed. It requires special approval for use by government agencies.
COST/COST SHARING CONTRACT
Cost and cost sharing contracts are appropriate when a new product will be developed which the supplier may be able to market elsewhere. This allows the supplier to have all their costs paid while developing a new product. Cost contracts are also often accepted by universities or other non-profit organizations. A cost sharing contract might be used when the supplier is not assured of a future market for the product or the supplier is not sure how large the market will be.
As with the fixed price incentive contract, the buyer must negotiate which costs will be covered. The supplier must allow the buyer to verify all costs and overhead rates. Close monitoring of this type of contract is essential to assure that waste is kept to a minimum.
COST PLUS INCENTIVE CONTRACT
Sometimes it is impossible to agree on a fixed price incentive contract because the item is so loosely defined that even a maximum price cannot be determined. The buyer may then agree to pay all costs but would like to have some incentives for the supplier to operate efficiently. This can be done by agreeing to pay all agreed upon costs. The contract will include all the elements of the fixed price incentive contract. It provides the supplier with assurance that all their costs will be covered and still provides some incentive to reduce such expenditures. As with all cost type contracts agreed upon costs and a method of rate verification must be negotiated prior to contract agreement.
COST PLUS AWARD FEE CONTRACT
Not a popular type contract. Usually employed by government agencies, if at all. This type contract allows the buyer to pay all agreed upon costs and add an amount of money as an "award" or fee at contract completion. The amount is completely decided by the buyer "after the fact."
COST PLUS FIXED FEE CONTRACT
This is the final type of cost contract that will be discussed. The supplier will again be reimbursed for all agreed upon costs. At the time of negotiation a fixed amount of money is negotiated which will be paid in addition to verified costs. This type of contract is used when the supplier has some idea of what costs will be but is unwilling to take a firm fixed contract without putting a large amount of fee in the contract to cover various contingencies that might occur.
TIME AND MATERIALS CONTRACT
A time and material contract is usually used for repair contracts. Until recently it was customary to include a "not to exceed" amount on the contract. Many firms used half the cost of a new unit to calculate the "not to exceed" value of the contract. Currently, it is more common to only place an amount on the contract that covers repair evaluation costs. A note is included which requires that the supplier contact the buyer and obtain approval prior to the repair being completed. This allows the buyer to decide if the repairs should be done or if the unit should be scrapped. on occasion a time and materials type contract is utilized by an independent contractor hired to complete a particular activity. In this case it is a fine line as to whether to utilize time and material or a cost type contract. Either would have the same effect. Profit in this type of contract is usually built into the contractor's hourly rate.
On occasion a large contract must be started before final negotiations are complete in order to assure delivery to a particular time schedule. When this situation arises it may require the use of a letter subcontract. Such a contract essentially releases initial work with a "not to exceed figure." The "not to exceed" amount is typically no more than 40% of the proposed price. It also contains a number of important contractual clauses such as an agreement to complete negotiations prior to completion of 40% of the total effort. Other special clauses as deemed necessary are included to protect both the supplier and the buyer. The contract effort at the time of placement is usually well defined and often completion milestones and preliminary progress payments are included.
INDEFINITE DELIVERY CONTRACT
An indefinite delivery contract is employed when the buyer is not sure of the production schedule or the quantity of material needed. There are three types of contracts employed:
- Definite Quantity Contract
- Requirements Contracts
- Indefinite Quantity Contract
When using the definite quantity contract delivery is not specified. Requirements contracts are those where your requirements are placed showing only a minimum quantity, which is guaranteed. This type of contract cannot be terminated at no charge as long as performance is acceptable. Indefinite quantity contracts provide that during a given period of time the buyer will place requirements with a specific supplier. Quantities and delivery dates are unknown, however minimum and maximum quantities are specified.
Often we find management most uncomfortable with any but firm fixed price contracts even when other types of contracting might allow us advantageous price and delivery. The choice should be advantageous to both the buyer and the supplier. It is our job as good buyers to alert them to all the possible alternatives.