Procurement contract: What it is and what are the different types
Learn what procurement contracts are, what key elements they should include, and how they have a profound positive impact on vendor relationships management.
Procurement professionals invest many hours sourcing vendors, negotiating supply terms, and ensuring they’re compliant with internal regulations. Ensuring vendors follow through with what’s been discussed and agreed upon is crucial to successful supply chain and supplier management.
The procurement contract (often called the purchase contract) is the catalyst to this processs. The procurement contract provides a written agreement outlining the rights and responsibilities of both parties involved in the deal.
In this article, we’ll look into what makes an effective procurement contract to help you and your procurement team avoid common pitfalls and ensure your contracts are watertight.
What is a procurement contract?
A procurement contract is a legally binding agreement between a purchaser (your company) and a supplier (your vendor). It describes what goods or services are expected to be provided by the vendor, specifications such as delivery dates or quality control requirements, and payment terms.
A well-designed procurement contract is the foundation for a successful and long-lasting supplier relationship. It allows both parties to ensure they’re fulfilling obligations by communicating them explicitly and in writing.
Procurement contracts also give vendors and buyers legal recourse should something in the relationship go south. It also serves as a reference when holding regular vendor review meetings.
The importance of procurement contracts
The biggest reason for implementing contracts in your procurement process is reliability.
You need to be able to rely on your suppliers to come through — to deliver what’s being asked of them. In many cases, they’re a crucial part of your business operations.
Procurement contracts put a formal agreement in place with agreed-upon details like delivery times and service performance expectations. Because they are legally binding documents, your vendors are unlikely to renege on the agreement, giving you more confidence in their reliability.
A good procurement contract also includes aspects of the agreement that you’re responsible for, such as monthly purchase order quantities and payment terms. This gives your vendor a little peace of mind too.
In short, procurement contracts provide a legal basis upon which a trusting vendor relationship can develop.
The procurement contract process, explained
In most cases, the buyer creates procurement contracts. The trigger for their creation is generally a verbal agreement.
Say, for example, you’ve decided to purchase a new SaaS tool, like a project management software.
You and the software vendor have discussed costs, delivery and implementation terms, and how they’ll help you handle setup and integration.
The next step is to put the agreement in writing using a procurement contract.
Fast-moving procurement teams often use templated contacts to get running quickly, generating these using their contract management platform, and editing terms and supplier details as appropriate.
At a high level, the typical process looks something like this:
- The project management team identifies what materials, services, staffing, and other resources are required and communicates needs to the procurement team
- The procurement team solicits bids from potential vendors
- After assessing multiple bidders, the procurement team selects a proposal
- A procurement contract is generated, approved by procurement leadership, and signed by both parties, formalizing the agreement
Types of procurement contracts
While every procurement contract looks slightly different — reflecting the specific needs of your organization — most agreements fall into one of three broad categories.
The fixed-price contract is the most straightforward of all procurement agreements.
Also known as a lump-sum contract, fixed-price contracts specify the products or services you will receive and the exact price you’ll pay for them.
Like all procurement contracts, they’ll also include other critical information like:
- Project terms
- Seller and buyer responsibilities
- Termination and dispute resolution clauses
The main benefit of fixed-price procurement contracts is consistency. Your vendor will continue to provide goods or services at the same price for the duration of the contract, regardless of any potential increase in cost of production on their end.
Depending on your relationship needs (and your supplier’s requirements), you can use one of three fixed-price procurement contracts:
- Firm fixed-price (FFP): In an FFP contract, you simply pay for what you get.
- Fixed-price & incentive fee (FPIF): FPIF contracts require buyers to pay an additional incentive fee if the supplier exceeds expectations (great for motivating performance and contract compliance).
- Fixed pricing with economic price adjustment (FPEPA): FPEPA contracts protect the vendor in the event that production costs change, allowing them to adjust their price (within terms stipulated in the contract).
In a cost-reimbursable contract, the buyer pays for the actual work completed, reimbursing the vendor for their various expenses, such as materials, wages, and utilities.
The vendor receives additional compensation above these costs depending on the structure of the contract:
- Cost plus fixed price (CPFP): The buyer pays a fixed dollar amount on top of cost reimbursement.
- Cost plus incentive fee (CPIF): The buyer pays a percentage fee on top of cost reimbursement.
- Cost plus award fee (CPAF): This is like the CPFP model, except the amount the buyer pays on top of cost reimbursement is discretionary (hence it's called an award).
Cost-reimbursable contracts are more common in one-off, labor-heavy projects. For instance, they’re useful if you contract a firm to build your company a new website. They’re less suitable in ongoing agreements like SaaS purchases or supply chain procurement.
Cost-reimbursable contracts put a lot more of the risk on the vendor. They have to bear the project costs up front and only receive payment once all costs are collected and verified. Plus, if the scope of work changes, the seller is, in most cases, responsible for bearing any additional costs.
Time and materials contracts
In a time and materials contract, the buyer agrees to reimburse the vendor for any materials used and pay them an hourly or day rate for their time. This is most common in agreements where most of the vendor’s effort is time, such as web development.
A time and materials contract outlines the supplier's rate and stipulates an upper limit for time and materials used. This is to mitigate the risk of a project’s costs exceeding the agreed-upon scope.
This kind of procurement contract is best used when the details of a project are difficult to envision and are likely to shift as the project develops.
Elements in a successful procurement contract
Solid procurement contracts include payment dates and terms, outline performance control measures, and discuss what should happen in the event of a dispute between the two parties.
Goods and services provided
This is the most basic element of a procurement contract, outlining the vendor's responsibilities for delivering products and services. This section should also include key dates and milestones for the project.
For instance, completing implementation of your new project management system could be considered an important milestone, and should have a date for expected completion attached.
Monitoring, reporting, and performance control
This section of the contract discusses how you’ll monitor contract compliance.
This might include responsibility on either side. The vendor may be responsible for providing production reports, and the buyer might be responsible for monitoring and approving quality.
Receipt, inspecting, and acceptance
Once the contract deliverables are received, the buyer must inspect and approve them or provide feedback for adjustments or replacements.
This section of the procurement contract outlines how this will take place, including key dates. For instance, the buyer may have a maximum of seven days to inspect and accept goods and to report any defects.
An effective procurement contract should include details of how and when either party can terminate the agreement.
We know, your goal is to build a long-lasting and flourishing relationship between both parties — you don’t want to be thinking about divorce just yet. However, part of drawing up a contract is creating protections for both parties, so this is a necessary process.
Outline the reasons for either party to terminate the contract and under what conditions. For example, you may be able to terminate the contract if the supplier falls into gross negligence of safety compliance regulations, and you may have to give 30 days' notice to do so.
Even the best contracts can be open to interpretation or fail to outline expectations under certain events. These can lead to disputes which halt the agreement and need to be settled formally.
Your procurement contract should include a section that discusses what each party should do to resolve a dispute. This is especially critical if you and your vendor are based in different countries, and the contract should outline in which jurisdiction the dispute will be settled.
Finances and payment
Key financial elements to include in the procurement contract include:
- How much is to be paid and how (lump-sum, installments, etc.)
- How it is to be paid (direct credit, check, etc.)
- Key payment dates (upon delivery, 1st of the month, 20th of the month, etc.)
The last of your contract terms should outline what defines the end of the contract.
In some cases, the contract may be perpetual and only terminated based on the terms outlined above. In others, contracts may be time-bound, such as in an agreement to develop a new website.
Include details on when the project is expected to conclude, what defines its completion, and how the two parties should communicate to agree the contract is complete.
Procurement contract management in Vendr
Getting a procurement contract in place is a crucial part of the vendor management process, but it’s not the last stop.
Once you’ve onboarded that new supplier, you’ll need to monitor contract compliance, measure vendor relationship strength and mutual fit, and manage potential risk.
Make this process seamless by bringing your vendor management processes into a centralized solution: Vendr.
Vendr is the SaaS buying platform that helps procurement teams cut costs, ensure compliance, and develop long-lasting supplier relationships.