The types of contracts within the purchasing department
The purchasing area is a sector that is under constant pressure in terms of cost reduction and performance optimization – both financial and operational. Contracts play a fundamental role in balancing this equation, after all, it is from them that processes take place.
We have already spoken here about the importance of contract management in purchasing – remembering that this process can be understood as the interaction between suppliers and buyers that guarantees the fulfillment of obligations by both parties. With effective supplier management, it is possible to avoid headaches and improve the company’s overall ratings.
5 pillars of effective supply chain management
Before commenting on each type of contract available on the market, let’s revisit the five pillars of effective supply chain management.
1. Supplier information management
For effective planning, it is necessary that the flow of information is unrestricted from one member of the supply chain to others. All such data must be stored, verified and made available to all interested parties.
2. Transparency and organization
It is necessary to manage suppliers in a transparent and organized manner. The objective is to recognize the value offered by its suppliers, whether tangible or intangible, making them key partners in the procurement processes.
3. Maintaining value
After establishing the value of suppliers, performance management is important so that good prices and good performances are maintained. A set of KPIs and goals to reflect expectations is essential to maintain performance control.
It involves ensuring that all purchase orders will be dispatched in a manner that meets the agreements stipulated by the buyer and the supplier, with a price and quality that meet what has been pre-established.
Suppliers must comply with their company’s policies and procedures, requirements that are normally specified in the contract.
5. SRM: the relationship with suppliers
It is a systematic approach to evaluate and add value to the contributions of suppliers within your organization, which, by storing detailed information on each one, improves the performance of the procurement processes, generating a positive impact on productivity, quality and even price negotiation of purchase.
A purchase contract can be summarized as a binding agreement between a buyer and a supplier, establishing the structure of the relationship between the parties.
But there is not just one type of purchase contract – it is ideal for every situation. They can be divided into three categories, each of which also has its subcategories. Below, we list each one of them:
Fixed price contracts
It is used when the scope of work is fixed: once the contract is signed, the seller is contractually obliged to complete the task within the agreed price and term. Therefore, the seller assumes most of the risk and there is no price renegotiation, unless the scope of the work changes.
As the cost cannot be changed, this contract is suitable for controlling expenses. We can divide a fixed price contract into three categories:
1. Company fixed price contract (FFP)
This is the simplest type of purchase contract. The supplier must complete the work within an agreed amount of money and time, and is responsible for covering any increase in operating costs and is legally required to complete the agreed task. However, as the supplier assumes the risk, the cost is higher, and if the scope is not clear, the supplier and the buyer may have problems.
2. Fixed price incentive fee agreement (FPIF)
Even if the price is fixed, the supplier can receive an incentive if it performs well – and that incentive lessens the risk. The incentive can be linked to any project metric, such as cost, time or technical performance. In practice, it works like this: a contractor receives an incentive of 6 thousand reais if he delivers everything on time, for example.
3. Fixed price with economic price adjustment contracts (FP-EPA)
This type of contract is used when the agreement is multi-year. A good differential is that it has a clause that protects the supplier from inflation. For example: you know that the cost of the project will increase by 1.5% after a time based on the Consumer Price Index – this would be a good type of contract for this case.
Refundable cost contracts
The supplier is reimbursed for the work completed, plus a fee representing his profit. This fee is received if it is met or exceeded for more objectives, such as completing tasks earlier or saving costs.
It is recommended when there is uncertainty in the scope or when the risk is greater. In this contract, the risk lies with the buyer, as he bears all the costs.
The increase in scope can be a disadvantage of this type of contract – but it is possible to minimize the increase by limiting, for example, the maximum profit to 10% of the total cost. Let’s assume that the purchase price is R $1,000.00 – in this case, if there is an adjustment, the price can only reach R $1,100.00. There are four categories of reimbursable cost contracts:
1. Cost plus fixed rate (CPFF)
The supplier is paid for all costs incurred plus a fixed fee, regardless of its performance, and the buyer assumes the risk. It is commonly used in high-risk projects where bidders do not want to compete.
2. Cost plus incentive fee (CPIF)
The supplier is reimbursed for all costs plus an incentive fee based on the fulfillment of certain performance objectives mentioned in the contract. This incentive will be calculated using a previously agreed formula, being, in this case, a motivating factor for the supplier.
3. Cost plus premium rate (CPAF)
The supplier is paid for the costs plus a premium fee, which is extra based on compliance with the performance objectives specified in the contract. The difference to the incentive rate is that the award depends on customer satisfaction.
4. Cost plus percentage of cost (CPPC)
In this case, the service provider must be reimbursed for costs projected and approved by the parties, plus a percentage of such costs or for a predetermined fixed remuneration.
It is usually the least viable for buyers, since suppliers can increase costs without justification, to obtain a higher profit, such as asking for the total cost plus 10% of the cost as a fee.
Contracts for time and materials
It is a kind of hybrid between Fixed Price and Refundable Contracts, where both parties share the risk.
It is usually used when it comes to “working hours” and when specialists are hired, such as a technician to repair a machine, for example. In this contract, the buyer can specify the hourly rate with a limit not to be exceeded, paying, for example, R$30 per hour.
Projects require a detailed discussion of goals, potential barriers to meeting them, the schedule and critical dates – and contracts are the basis for these definitions determining the responsibilities of the parties.
Therefore, choosing the right category of contract is fundamental to the satisfaction of both parties: both the buyer and the supplier.
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