Managing suppliers is an area that you cannot operate, in life really, without understanding. That is why it becomes more important to understand the basics of it in the project environment. One session in class, we covered the different types of contracts with the focus on the incentive type contracts.
This is always a topic that fascinates me regardless of how complicated it is. It always indicates how savvy organisations have become to make business with vendors and partners while mitigating financial risks on so many level.
Let’s say you go buy a new iMac. Immediately, Apple suggests that you buy Apple care with it to extend its warranty. Warranty is key over here. You have just bought insurance. Insurance is used to transfer any financial cost arising from an incident. But this is between a customer and a retailer. Here are some contract options that business exchange for different purposes:
1. Fixed-Price Contracts
2. Cost-Reimbursement Contracts
3. Time-Material contracts
Lets define those 3 types of contracts and give simple examples to put them in context.
1. Fixed-Price Contracts:
These types of contracts are the most commonly used contracts. They are straight forward type of contracts. I want something from you. This “something” is a product or a service that is clearly defined and both parties have full understanding of its requirement and any potential risks that might arise.
The advantages of this type of contracts is that it can be used to buy stuff off the shelf. It encourages the contractors to deliver the product or service that you are purchasing.
So when it sounds so simple and straight forward, why could it have disadvantages? Think of a project that spans for 10 years. You are the project manager who is planning our procurements and their budgets. You can get a fixed price to buy something on year 6 of the project plan. The price is fixed and you know how much money to put aside. The question is: what if on year 6, the materials (products or service) you had bought undergone significant cost reductions due to certain economical situations. You wouldn’t benefit from this price drop because your contract is fixed price. This by itself is a disadvantage. 78% of projects run over budget. So as a project manager you could potential seek every opportunity to save money.
2. Cost-Reimbursement Contracts
While this sounds from its name as a fair approach to contracts, if you are the project manager and you are seeking to set up contracts with suppliers, you have got to think carefully. This type of contracts is set for you to pay the cost of material and services used plus an agreed fee to your supplier.
So now if your project has a scope that is not fully developed i.e. some requirements are not fully gathered, you will not be able to sign a fixed-price contract. But you also need to move ahead and secure a contractor so your project can progress. This is where these contracts come in hand. The only thing to be mindful of is when budgeting for the project implementation and costs, the estimates are at risk of being way off chart, especially if your project has a schedule of years rather than months. The cost of some material could change dramatically by the time you get to the stage of needing these material. The supplier will not be impacted a lot as they will bill your project the entire cost.
3. Time-Material Contracts:
When you are faced in an emergency and you know there is a quick fix to it, the key is in the word quick, this type of contacts would work wonders. This is because you are paying a contractor to use their products and services based on the time they take to finish the work and the material they use. To put it into context, think of the plumber or electrician you called to fix a disaster that happened at your home. You are paying them their hourly rate plus any additional material they get.
Same thing for your project! if you have something that is short-term and of a small amount, then this type of contract would help. However, you have to be very careful with this type of contract to avoid situations when your supplier is purposely performing in the slowest way possible to extend the estimated time it takes a job.
With the above three types of contracts, this post is not to favour one over the other. It is aimed to introduce these types of contracts that take place as each one caters a different situation. And with each situation, one type of contract would prove fit for purpose.
Throughout my career, I had to deal with vendors in my day-to-day job. But I was never in charge of negotiating their contracts. There is always someone specialised in procurement and understand the legalities of contracts that does that work. But understanding the basics of these types of contracts has helped a lot in understanding certain vendor’s behaviour in different situation when efficiencies or speed in delivering the service or product is in question.
Another reason why understanding these types of contracts is important, because as you assess the level of risk involved in your project, the opposite level of risk holds true to your contractor. Meaning, if fixed-price contracts are of low risk to your project, they are of high risk to your contractor. And this applies to the other 2 types of contracts. So when you understand how risk is managed for you and for them, you will be able to negotiate the right type of contract and get them on board with your project.