Protect Against Third-Party Risk With Better Procurement Contracting
Procurement contracts, sometimes called purchase contracts, are legal agreements between buyers and sellers. They are the terms and conditions that govern a business relationship where the purchase and sale of goods and services are involved.
Procurement contracts define exactly what the buyer is getting from the seller. It gives the seller the comfort of knowing exactly what they need to supply to a buyer without the risk of unexpected demands. They know what they need to do to perform the contract satisfactorily.
In this article, we cover:
- The role of contracts in the procurement process
- The different types of procurement contracts
- How procurement contracting works
- The best practices in procurement contract management
- How to avoid risk in your procurement contracting procedures
The Role of Contracts in Procurement
Procurement is the sourcing, negotiating, and purchasing of products and services from third parties.
Colleagues within an organization will tell procurement teams that the business needs a particular product or service to overcome a problem or take advantage of an opportunity.
Procurement teams will then approach a number of potential suppliers, shortlisting the ones they think are going to be the most likely to provide a satisfactory outcome. They will then negotiate deals on price and delivery with these suppliers and select one of them to proceed with.
Seems straightforward so far. But the procurement process is actually far more complicated.
For the chosen supplier to be able to deliver on time and within budget to you, they will often be reliant on their own supply chain. A breakdown in one part of the chain because of something like transportation problems, a technology fault, or an inability to source a particular material at a given time could cause your supplier to fail to meet their obligation to you.
This is where procurement contracting comes in.
What prevents issues like these from becoming problems are contracts. Contacts tell each supplier in a chain what their responsibilities are and what expectations others have of them. Not only does that prevent misunderstandings, but it forces suppliers to create contingency plans to overcome those problems.
The most robust supply chains have clockwork-like predictability to them, often no matter what’s going on in the outside world.
Types of Procurement Contracts
There are three main types of procurement contracts in supply chains: fixed-price contracts, cost-reimbursable contracts, and time and materials contracts. Let’s take a look at each one.
1. Fixed-Price Contracts
As known as fixed-fee contracts, these set a defined price for a product or service at the outset of a supply agreement. They are lump-sum contracts where the buyer pays the seller either in installments or when the contract is completed.
There are three variations on fixed price contracts:
- Firm fixed-price contract (FFP): The contractor is completely responsible for risk management, and they’re not allowed to change the price under any circumstances to reflect unexpected or additional work that the agreement requires them to carry out.
- Fixed-price incentive fee contract (FPIF): The buyer may pay the seller more for better performance during the contract. The level of extra payment and the conditions under which bonuses are triggered are set out in the governing contract.
- Fixed price with economic price adjustment contract (FP-EPA): A seller may increase their prices to reflect changes in market conditions or the wider economy, like rises in material costs, labor rates, and inflation.
2. Cost-Reimbursable Contracts
Also known as cost-plus contracts, cost-reimbursable contracts involve the buyer paying for the full cost of the work carried out plus a pre-agreed profit level for the supplier. Costs covered include direct costs like equipment and materials as well as indirect costs like utilities and wages. The pre-agreed profit may be a fixed fee or a percentage of the total project cost.
The budget and schedule are estimates, and they can change during the course of contract fulfillment. This type of contract, therefore, exposes the buyer to the risk that they may have to pay more if actual costs are higher than expected.
3. Time and Materials Contracts
Time and materials contracts are another option for procurement contracting teams. They are very similar to cost-reimbursable contracts but are more often used by professionals like software developers. They’re designed for supply agreements where not many materials need to be purchased to fulfill a contract.
Time and materials contracts often do not have a fixed maximum budget. This exposes the buyer to the risk of escalated costs if the project takes longer than anticipated or the scope changes significantly during implementation.
How the Procurement Contracting Process Works
Although there may be slight variations in workflows in procurement contract management between companies, the following steps are common:
- Choosing vendors and establishing contract requirements: At this stage, the procurement team finds out what a potential vendor needs to fulfill a contract, including materials and services provided, staffing needs, technical specifications, and other matters.
- Drafting the procurement contract: The legal or procurement team drafts a contract based on the scope and deliverables for the product or service being ordered. They then send this to the seller for review.
- Negotiating contract terms with counterparties: At this point, buyers and sellers negotiate, sending the governing agreement back and forth, until a consensus is reached. This is often the most time-consuming and resource-intensive stage for all stakeholders during the procurement contracting process.
- Sending the procurement contract for signing: When the buyer and seller are in agreement, the contract is signed. A purchase order may be sent out at this point. Electronic signatures are now widely accepted.
- Managing compliance post-signature: Once work is underway, the buyer’s project manager checks that the seller is fulfilling their contractual obligations. If not, they bring those deficiencies to the seller’s attention. Likewise, the seller’s project manager monitors seller performance through the contract lifecycle, often on issues like adherence to payment terms.
Best Practices in Contract Administration
Procurement contracting is complicated. You should exercise a high level of due diligence when onboarding suppliers, vendors, and other third parties.
The strongest supplier relationships develop where there is a precise legal agreement and both parties know exactly what’s expected of them.
To give yourself the best chance of achieving that outcome, take the following precautions:
- Negotiate every detail: On all major points of substance, make sure you thoroughly discuss and agree on everything. Satisfy yourself to the best of your abilities that the other party fully understands everything you want so you avoid disputes later on.
- Be clear on everything: The greater the detail and level of clarity, the better. Define all key terms and conditions, especially in relation to payment terms, timelines and milestones, final deliverables, and the overall scope of work.
- Set expectations: Go further and set targets in your procurement contracts for your supplier to meet in areas like cost control, quality standards, delivery times, and more.
Even as you and your suppliers get used to working with each other, review contracts on a regular basis to identify opportunities for cost savings and greater efficiencies. Run frequent checks on their performance, and where you see an opportunity to make an adjustment in your favor, take it.
Avoiding Risk in Procurement Contracting
There are inherent risks in dealing with all third parties. Here are a few pointers on how to mitigate risk in the procurement contracting process:
- Third-party evaluation: Reputation is important. Check that your counterparty is not subject to the OFAC 50 rule or a politically exposed person (PEP). Make sure you find out as much as you can about their current compliance with applicable laws and regulations as well as their general reputation and track record. Running credit checks on their financial stability is also cost-effective and prudent, as this information may stop you from contracting with unreliable third parties.
- Risk allocation: Increasingly within supply agreements, both parties build in risk management. This is to put a price on responsibility for non-compliance, cost overruns, and delays. So, if a supplier delivers late and that costs you money, they have to meet some or all of that cost.
- Use of contract templates: Consider using templates as the starting point for your agreement. These are standardized contracts that have already been checked for efficacy by legal experts. You and your supplier can then amend and customize the template to fit your specific relationship and the transaction it covers.
- Legal review: That said, get a lawyer to check the contract before you sign for a final check that performance of the contract will be compliant and free from legal risk. Your lawyer may also spot an opportunity to modify the contract further to protect your interests.
Protect Against Third-Party Risk With Better Procurement Contracting
Procurement contracts, sometimes called purchase contracts, are legal agreements between buyers and sellers. They are the terms and conditions that govern a business relationship where the purchase and sale of goods and services are involved.
Procurement contracts define exactly what the buyer is getting from the seller. It gives the seller the comfort of knowing exactly what they need to supply to a buyer without the risk of unexpected demands. They know what they need to do to perform the contract satisfactorily.
In this article, we cover:
- The role of contracts in the procurement process
- The different types of procurement contracts
- How procurement contracting works
- The best practices in procurement contract management
- How to avoid risk in your procurement contracting procedures
The Role of Contracts in Procurement
Procurement is the sourcing, negotiating, and purchasing of products and services from third parties.
Colleagues within an organization will tell procurement teams that the business needs a particular product or service to overcome a problem or take advantage of an opportunity.
Procurement teams will then approach a number of potential suppliers, shortlisting the ones they think are going to be the most likely to provide a satisfactory outcome. They will then negotiate deals on price and delivery with these suppliers and select one of them to proceed with.
Seems straightforward so far. But the procurement process is actually far more complicated.
For the chosen supplier to be able to deliver on time and within budget to you, they will often be reliant on their own supply chain. A breakdown in one part of the chain because of something like transportation problems, a technology fault, or an inability to source a particular material at a given time could cause your supplier to fail to meet their obligation to you.
This is where procurement contracting comes in.
What prevents issues like these from becoming problems are contracts. Contacts tell each supplier in a chain what their responsibilities are and what expectations others have of them. Not only does that prevent misunderstandings, but it forces suppliers to create contingency plans to overcome those problems.
The most robust supply chains have clockwork-like predictability to them, often no matter what’s going on in the outside world.
Types of Procurement Contracts
There are three main types of procurement contracts in supply chains: fixed-price contracts, cost-reimbursable contracts, and time and materials contracts. Let’s take a look at each one.
1. Fixed-Price Contracts
As known as fixed-fee contracts, these set a defined price for a product or service at the outset of a supply agreement. They are lump-sum contracts where the buyer pays the seller either in installments or when the contract is completed.
There are three variations on fixed price contracts:
- Firm fixed-price contract (FFP): The contractor is completely responsible for risk management, and they’re not allowed to change the price under any circumstances to reflect unexpected or additional work that the agreement requires them to carry out.
- Fixed-price incentive fee contract (FPIF): The buyer may pay the seller more for better performance during the contract. The level of extra payment and the conditions under which bonuses are triggered are set out in the governing contract.
- Fixed price with economic price adjustment contract (FP-EPA): A seller may increase their prices to reflect changes in market conditions or the wider economy, like rises in material costs, labor rates, and inflation.
2. Cost-Reimbursable Contracts
Also known as cost-plus contracts, cost-reimbursable contracts involve the buyer paying for the full cost of the work carried out plus a pre-agreed profit level for the supplier. Costs covered include direct costs like equipment and materials as well as indirect costs like utilities and wages. The pre-agreed profit may be a fixed fee or a percentage of the total project cost.
The budget and schedule are estimates, and they can change during the course of contract fulfillment. This type of contract, therefore, exposes the buyer to the risk that they may have to pay more if actual costs are higher than expected.
3. Time and Materials Contracts
Time and materials contracts are another option for procurement contracting teams. They are very similar to cost-reimbursable contracts but are more often used by professionals like software developers. They’re designed for supply agreements where not many materials need to be purchased to fulfill a contract.
Time and materials contracts often do not have a fixed maximum budget. This exposes the buyer to the risk of escalated costs if the project takes longer than anticipated or the scope changes significantly during implementation.
How the Procurement Contracting Process Works
Although there may be slight variations in workflows in procurement contract management between companies, the following steps are common:
- Choosing vendors and establishing contract requirements: At this stage, the procurement team finds out what a potential vendor needs to fulfill a contract, including materials and services provided, staffing needs, technical specifications, and other matters.
- Drafting the procurement contract: The legal or procurement team drafts a contract based on the scope and deliverables for the product or service being ordered. They then send this to the seller for review.
- Negotiating contract terms with counterparties: At this point, buyers and sellers negotiate, sending the governing agreement back and forth, until a consensus is reached. This is often the most time-consuming and resource-intensive stage for all stakeholders during the procurement contracting process.
- Sending the procurement contract for signing: When the buyer and seller are in agreement, the contract is signed. A purchase order may be sent out at this point. Electronic signatures are now widely accepted.
- Managing compliance post-signature: Once work is underway, the buyer’s project manager checks that the seller is fulfilling their contractual obligations. If not, they bring those deficiencies to the seller’s attention. Likewise, the seller’s project manager monitors seller performance through the contract lifecycle, often on issues like adherence to payment terms.
Best Practices in Contract Administration
Procurement contracting is complicated. You should exercise a high level of due diligence when onboarding suppliers, vendors, and other third parties.
The strongest supplier relationships develop where there is a precise legal agreement and both parties know exactly what’s expected of them.
To give yourself the best chance of achieving that outcome, take the following precautions:
- Negotiate every detail: On all major points of substance, make sure you thoroughly discuss and agree on everything. Satisfy yourself to the best of your abilities that the other party fully understands everything you want so you avoid disputes later on.
- Be clear on everything: The greater the detail and level of clarity, the better. Define all key terms and conditions, especially in relation to payment terms, timelines and milestones, final deliverables, and the overall scope of work.
- Set expectations: Go further and set targets in your procurement contracts for your supplier to meet in areas like cost control, quality standards, delivery times, and more.
Even as you and your suppliers get used to working with each other, review contracts on a regular basis to identify opportunities for cost savings and greater efficiencies. Run frequent checks on their performance, and where you see an opportunity to make an adjustment in your favor, take it.
Avoiding Risk in Procurement Contracting
There are inherent risks in dealing with all third parties. Here are a few pointers on how to mitigate risk in the procurement contracting process:
- Third-party evaluation: Reputation is important. Check that your counterparty is not subject to the OFAC 50 rule or a politically exposed person (PEP). Make sure you find out as much as you can about their current compliance with applicable laws and regulations as well as their general reputation and track record. Running credit checks on their financial stability is also cost-effective and prudent, as this information may stop you from contracting with unreliable third parties.
- Risk allocation: Increasingly within supply agreements, both parties build in risk management. This is to put a price on responsibility for non-compliance, cost overruns, and delays. So, if a supplier delivers late and that costs you money, they have to meet some or all of that cost.
- Use of contract templates: Consider using templates as the starting point for your agreement. These are standardized contracts that have already been checked for efficacy by legal experts. You and your supplier can then amend and customize the template to fit your specific relationship and the transaction it covers.
- Legal review: That said, get a lawyer to check the contract before you sign for a final check that performance of the contract will be compliant and free from legal risk. Your lawyer may also spot an opportunity to modify the contract further to protect your interests.
Use Certa in Your Procurement Contracting Processes
Certa’s built-in set of features can streamline your procurement contracting workflows with the following:
- Pre-existing contract templates and clause libraries: Auto-draft contracts to ensure consistency and reduce the risk of errors or omissions.
- Document versioning: Keep copies of all prior forms and documents with highlighted changes. Streamline revision management and keep everyone on the same page with the Box Sign integration.
- Audit trails: See every single edit, view, notification, and alert for a comprehensive overview of all activity
- Integrated e-signature services: This functionality means you can quickly and securely complete procurement contracting online.
- Collaboration tools: Features like tagging, commenting, and in-app messaging allow everyone in your business to monitor contract changes and progress.
- Dashboards and reporting: Get a 360-degree view of contracts at all stages.
- Built-in milestone management: Gain an advanced calendar notification of deadlines, auto-renewals, expirations, and more.
Talk with our experts today to see how Certa can help you with your procurement contracting process.
