Types of procurement contracts: Understanding when and how to use each

A procurement team's decisions hinge on selecting the right contract, the document that protects your business while establishing clear expectations for pricing, quality, delivery, and dispute resolution. Finding the perfect contract structure allows your team to balance risk management with operational flexibility, creating partnerships that foster innovation rather than just transactions.

In this guide, we'll cover the types of procurement contracts, their key components, and how to choose the right one.

What is a procurement contract?

It's a necessary tool to ensure both parties are protected and understand the terms of the agreement they're entering into. This helps prevent disputes and strengthens the supplier relationship by building trust on both sides.

Procurement contracts are crucial for mutually beneficial relationships with your vendors and suppliers. Their role is to assist with open communication, negotiating fair terms, and establishing clear expectations. They become catalysts for strategic alliances, unlocking opportunities for innovation, cost savings, and operational excellence.

Why are procurement contracts important?

When procurement contracts are executed with precision and foresight, they help cultivate trust and foster long-term partnerships. These agreements are cornerstones that ensure seamless collaboration, reliable delivery, and the alignment of shared goals because they:

• Provide legal protection: They outline the rights and responsibilities of both parties in case of disputes or breaches
• Define the scope of work: This includes deliverables, timelines, and quality standards, ensuring both parties are on the same page
• Mitigate risks: They address issues such as payment terms, warranties, indemnification clauses, and liability limitations
• Control costs: They prevent unexpected expenses by detailing pricing structures, payment schedules, and penalties for non-performance
• Address compliance: This ensures both parties adhering to relevant laws, regulations, and industry standards, reducing the risk of non-compliance and associated penalties
• Facilitate dispute resolution: This is accomplished through mediation, arbitration, or litigation, minimizing the likelihood of costly legal battles
• Include confidentiality clauses: This is to protect sensitive business information and intellectual property rights
• Foster trust and transparency: They strengthen the long-term relationship between buyers and suppliers

Having robust procurement contracts provides a framework for both the buyer and the seller to operate within. Thus it enables competitive market dealings and ensures the fulfillment of obligations between parties.

By outlining the specific requirements, deliverables, and timelines, procurement contracts help to create a level playing field for potential suppliers. This encourages competition, as suppliers strive to differentiate themselves and offer the best value proposition.

Key components of a procurement contract

Understanding the building blocks of procurement contracts helps you navigate negotiations with confidence and draft agreements that protect your business interests. These essential elements form the foundation of effective contracts.

When drafting or creating a template for a procurement contract, make sure that you:

1. Clearly identify the parties entering into the contract
2. Define the goods or services to be provided
3. Detail the pricing structure, payment terms,and invoicing procedures
4. Establish key performance indicators (KPIs) and metrics
5. Specify the duration of the contract, renewal options, and termination conditions
6. Outline any warranties, guarantees, or assurances provided by the supplier
7. Include provisions to protect sensitive information, as well as compliance with data protection regulations
8. Define each party's liability limits, indemnification obligations, and dispute responsibilities
9. Specify the governing law of the contract, jurisdiction for disputes, and conflict resolution procedures
10. Include provisions for making changes to the contract and outline the process for approval

All of these key components should go into any procurement contract type. But some contracts may have additions, depending on the type.

Main types of procurement contracts

Selecting the right contract type can significantly affect project outcomes, cost management, and risk allocation between parties. Familiarity with the various procurement contract types empowers you to choose structures that align with your business needs and objectives.

Fixed-price contracts

A fixed price contract is an agreement where the buyer pays the seller a predetermined, unchanging amount for the complete delivery of goods or services, regardless of the actual costs incurred during execution. This contract type places most of the financial risk on the supplier, who must deliver the specified deliverables within the agreed budget.

Fixed price contracts provide budget certainty for buyers and are typically used when requirements are clearly defined, stable, and unlikely to change significantly during the contract period.

This type of contract offers several advantages, such as:

• Knowing the exact cost of the project up front, allowing for better budgeting
• Incentivizing the supplier to complete the project efficiently
• Limiting your financial risk to the fixed contract price and not any cost overruns

For example, if you hired a contractor to renovate your office space, a fixed price contract would outline the work to be done, and the contractor would provide a price for the entire project. This price would be locked in and wouldn't change unless certain key components are included, depending on the form of fixed-price contract you're using.

Firm-fixed-price (FFP)

In this type of procurement contract, the price doesn't change for the buyer regardless of how project costs may change. For example, you hire a contractor to renovate your office. They quote you a price based on their material and labor costs. Then those material prices rise. Your firm, fixed price remains the same, and the supplier is responsible for the additional costs.

Fixed-price-and-incentive-fee (FPIF)

This procurement contract type also uses a fixed price that doesn't change regardless of how the supplier's costs may change, but pays an additional fee for meeting or exceeding performance metrics. For instance, if the contractor renovating your office finishes the project a week ahead of schedule, you'll pay them an incentive fee over and above the fixed price of the project.

Fixed-price-with-economic-price-adjustment (FP-EPA)

In this type of contract, a fixed price is set but may change according to external economic factors. For example, your contractor quotes you a price to renovate your office based in part on how much the cubicles will cost. Then, in the middle of the project, those cubicle prices go up. You'll still pay the base fixed price plus the difference between the initial and adjusted cubicle prices.

Each type of procurement contract offers different benefits and risks, so it's important to carefully consider the specific requirements of the procurement project before selecting the most appropriate contract type.

Cost-reimbursable contracts

Cost-reimbursable contracts are a type of procurement contract where you reimburse the supplier for the actual costs incurred, plus an additional fee or profit margin. These contracts are commonly used for projects with a high degree of uncertainty or complexity, where it is difficult to accurately estimate the total cost upfront.

Cost-reimbursable contracts offer several benefits, like:

• Flexibility for both parties to adapt to changing project requirements
• Sharing of risks between you and the supplier for actual costs incurred
• Incentivizes suppliers to propose innovative solutions and technologies
• Provides transparency and visibility into project expenses
• High-quality results as the supplier’s fee may be tied to meeting performance criteria

For example, a fixed-price contract might be risky due to the complexity and potential unknowns in an office renovation project.

Instead, you can opt for a cost-reimbursable contract, which will reimburse the contractor for their allowable costs incurred during the renovation (typically including labor, materials, permits, and equipment rentals). The contractor would also get a fee on top of the reimbursed costs. The key components of the project will depend on the type of cost-reimbursable contract you choose.

Cost-plus-fixed-fee (CPFF)

In this type of procurement contract, the contractor is reimbursed for all allowable expenses plus an additional fixed payment as profit or overhead. It's ideal when exact project costs might be difficult to estimate up front.

For example, you hire a contractor to renovate your office, located in an older building where hidden problems might be discovered once walls are opened up. Since the full scope of work can't be determined until demolition begins, a cost-plus-fixed-fee arrangement makes sense.

The contractor would document and bill you for all actual costs, plus receive an agreed-upon fixed fee to cover their management and profit. This protects you from a contractor padding estimates to cover unknown risks, while ensuring they don't lose money if unexpected issues arise.

Cost-plus-incentive-fee (CPIF)

This type of contract reimburses a contractor for all allowable expenses while offering an additional performance-based bonus that increases when they achieve specific targets like completing work under budget or ahead of schedule.

When that contractor renovates your office, you'll reimburse them for all their expenses, plus pay a fee if, for example, they finish the job two days early.

Cost-plus-award-fee (CPAF)

In this type of contract, a contractor is reimbursed for all allowable expenses while having an opportunity to earn additional payment based on subjective evaluations of their performance quality, innovation, or customer satisfaction.

This arrangement incentivizes higher quality work from the contractor. Only you'll be able to determine whether to award the additional fee. For instance, if you're happy with the office renovation and you feel the work is of high quality, you can award the fee. If you feel the contractor did the bare minimum, you're not obligated to award the fee.

Cost-plus-percentage-of-cost (CPPC)

This procurement contract type reimburses a contractor for all allowable expenses plus pays an additional fee calculated as a percentage of those costs. This transparent approach ensures the contractor is fairly compensated for their work while allowing their profit to scale proportionally with the project's actual costs.

When that contractor renovates your office, you'll pay the renovation costs including materials and labor, plus a percentage of those costs. It's worth noting this arrangement may not incentivize cost control since higher expenses generate a larger fee. This contract type is often more beneficial for the contractor than the buyer, so choose your contractor and contract type wisely.

Time and material contracts

With a time and materials contract, you pay the supplier based on the actual hours worked and materials used to complete a project, rather than a fixed price. This type of procurement contract is commonly used in situations where the scope of work is difficult to define up front or is subject to change during the course of the project.

Some benefits of this type of contract are:

• Flexibility for you and the supplier to adapt to changing project requirements
• Provides cost control as you have visibility into actual hours worked and materials used
• Makes project costs transparent for both parties
• Incentivizes efficient and effective work
• Allows for the sharing of risks between you and the supplier

Continuing with the office renovation example, a time and materials contract will outline hourly rates for the contractor's workers and an agreed-upon method for calculating material costs (often with a markup for the contractor to cover purchasing and handling). So if the hourly rate is $100 and the office renovation takes 160 labor hours, you'll owe $16,000, plus the cost of materials.

The contractor will then submit invoices with detailed records of labor hours and material usage and bill you for the same.

Clearly spelling out the terms and conditions of a time and materials contract will help everyone understand what's expected, what their responsibilities are, and keep everyone's goals aligned throughout the project.

How to choose the right procurement contract type

Selecting the right type of procurement contract for your project requires considering some key factors, from understanding your project needs to evaluating market conditions.

Remember, there's no one-size-fits-all answer. The best procurement contract type balances your specific project needs, risk tolerance, and relationship dynamics.

Other considerations

Beyond the main contract types, a specialized option may better suit your specific procurement needs. There are three additional contract structures that could provide the right framework for your project:

• Indefinite Delivery/Indefinite Quantity (IDIQ) Contract: Allows you to establish a relationship with suppliers for recurring needs when the exact quantities and delivery schedules aren't known in advance
• Lump-Sum Contract: Provides budget certainty by establishing a fixed total price for all required work, transferring most of the risk to the supplier
• Incentive Contract: Aligns vendor performance with your business goals by offering financial rewards for exceeding targets in areas like quality, timeliness, or cost control

Evaluating these specialized types of procurement contracts alongside standard options ensures you select the most advantageous procurement structure for your specific project requirements and business constraints.

Using technology for procurement and contracts management

Digital contract management software can bring numerous benefits to your procurement and contract processes by streamlining operations, improving efficiency, reducing costs, enhancing transparency, and mitigating risks.

Here are some ways in which your procurement management can benefit by leveraging technology:

• Automating manual tasks such as data entry, document processing, and approval workflows, saves time and reduces human errors
• E-sourcing platforms and e-procurement tools facilitate electronic sourcing, bidding, and vendor management processes, which can lead to faster procurement cycles
• Using Contract Lifecycle Management (CLM) systems can help you manage contracts from creation to execution to renewal
• Spend analysis tools can help you analyze procurement data to identify spending patterns, cost-saving opportunities, and supplier performance metrics

Ramp has the potential to transform procurement and contracts processes, driving efficiency, transparency, and compliance while enabling you to make data-driven decisions and optimize your supply chain management practices.

Ramp's all-in-one procurement solution is an ideal investment if you’re looking to improve efficiency, enhance transparency, and maintain compliance in your procurement and contract processes.