What is Procurement, Purchasing, Types of Contract and the Risk Factors Involved
Questions like what is the difference between Procurement or Purchasing, Agreement or Contract, how to select the Procurement Contract,
who carries the risk in which kind of Contract and many more are answered in this article.
An article is a good place for a reader to start understanding different concepts in Project Procurement Management for the PMP Certification Exam.
What is Procurement
Procurement is the process of finding and agreeing to terms, and acquiring goods, services, or works from an external source, often via a tendering or competitive bidding process
Purchasing or Procurement; what should be your focus
- Purchasing consists of the last explicitly transactional steps found at the end of the overall procurement process.
- Procuring deals with sourcing, negotiation, and strategic selection, which must occur before the purchasing of any products or services can be had.
What is Contract
A contract is an agreement between two parties creating a legal obligation for both of them to perform specific acts. Each party is legally bound to perform the specified duties such as rendering a payment or delivering goods.
A contract should have
- Mutual Assent
- Offer and Acceptance
Contracts usually provide
- Reference to Buyer and Seller
- Scope of Work/Project Scope Statement
- Payment Method
- Payment Schedules
- Terms and Considerations
- Force majeure
- Acceptance Criteria
- Early Exit Criteria
- Change management
- Claims Procedure
- Laws to adhere to
- Mitigation Process
What is Agreement
When a person (promisor) offers something to someone else (promisee), and the concerned person accepts the proposal with equivalent consideration, this commitment is known as the agreement.
Contract and Agreement
- All contracts are an agreement, but all agreements are not contracts
- Those which bind us legally are known as a contract, while the rest are agreement.
- An agreement needs not to be given in writing, but the contracts are normally written and registered.
- The agreement does not legally bound any party for the performance. In the Contract, the people are legally bound to perform their part.
Types of Contracts
What are the different kinds of procurement contracts?
1. Fixed Price Contracts
2. Cost Reimbursable Contracts
3. Time and Labour Contract
Fixed Price Contracts (FPC)
A Fixed-Price contract aka Lump-Sump contract is a contract between seller and buyer that has a predetermined-set price/fixed price for a specific product or service with usually no uncertainty in the scope of work. The change of scope usually follows stringent change management policies.
Firm Fixed Price Contracts
An FFP is the most common type of fixed-price contract. In an FFP contract that scope of the product or service should be exact. The price will be set on the buyer’s request. not subject to change unless the scope of work changes.
Fixed Price Incentive Fee
An FPIF offers a performance-based incentive over and above the fixed price if the product or service exceeds an expectation. The KPI’s and metrics can be defined at the beginning so that both parties can wok to attain that. Typically, such financial incentives are related to cost, schedule, or technical performance of the seller
Fixed Price with Economic Price Adjustment
An FP-EPA is like an FFP, with one exception, a special provision allowing for predefined final adjustments to the contract price due to changed conditions. This is useful when the project is largely reliant on input with a price that is governed by supply and demand, a seller could increase/decrease the price of the overall contract accordingly.
Cost Reimbursable Contracts or Cost Plus Contracts
Cost-reimbursement contracts mean that buyers will pay all legitimate cost incurred by the seller plus an agreed-upon fee that could be fixed or percentage for the Scope of work agreed in the contract.
Cost Plus Fixed Fee (CPFF)
In a CPFF the seller can charge the buyer for all legitimate expenses related to completing the product or service plus the additional fixed fee. The fee amount can change if the project scope changes.
Cost Plus Percentage Fee (CPPF)
In a CPPF the seller can charge the buyer for all legitimate expenses related to completing the product or service plus the additional percentage fee as defined in the contract.
Cost Plus Incentive Fee (CPIF)
Buyer will pay all the cost and the additional costs are paid an incentive based on the performance.
Cost Plus Award Fee (CPAF)
A CPAF is very similar to the CPIF, but the majority of the fee is earned based on the satisfaction of certain broad subjective performance criteria that are defined and incorporated into the contract.
Usually, these contracts are used when Scope of work is loosely defined usually because of the lack of information about the project scope and therefore it is expected that scope of work will change significantly during the execution of the contract.
Time and Material Contracts
T&M contracts are a cross between fixed-price and cost-reimbursable. T&M are typically used when the scope of work cannot be well defined when the contract is created.
Risks on the Project
- The seller bears the majority of the risk in the Fixed Price Contract as he might need to bear the cost of price increase or some additional scope.
- The buyer bears the majority of the risk in Cost Plus Contracts
- Time and Material, the risk is shared but the buyer does carry additional risks as it is his responsibility to make sure that hired or rented resources are delivering.
Advantages and disadvantages of the Purchasing Contracts
- Fixed-Price contract has the fixed scope of the work, and the total cost of the task before the work begins.
- Disputes on the Scope of work is pretty common with FFP
- With FP, sellers may try to cut the scope to keep it beneficial for the seller (i.e deliver within time and budget)
- The buyers usually avoid CP Contracts because the seller might artificially increase the cost to earn a higher profit.
- FPEPA are used whenever the seller’s performance period spans a considerable period of years, or if the payments are made in a different currency
How to select a contract type?
There are many factors which govern the selection of the contract;
- Complexity and Understanding of the Requirements
- Type of resources and services required
- Market conditions i.e availability of Suppliers and Contractors
- Frequency of Changes
- Best Practices in the Industry
- The risk appetite of the company
- Local Laws
- PMBOK Guide Ver 6.0
- Contracts–from the vendor and the buyer point of views
Brannan, L. & Lee, W. (2007). Contracts—from the vendor and the buyer point of views. Paper presented at PMI® Global Congress 2007—North America, Atlanta, GA. Newtown Square, PA: Project Management Institute.