There are a few basic forms of contracts. The differences between them can be broken down to who accepts more of the risk if there are increases in cost or schedule overruns.
Fixed-Price Contracts
Firm fixed-price contracts minimize the risk for the customer because the supplier must absorb all cost overruns. These contracts are appropriate for products and services that have a market value that is easy to determine, or that have costs which are otherwise reliably estimated.
Firm Fixed-Price Contract – A contract in which the seller is paid a set price without regard to costs.
Cost
A pure cost-based contract minimizes the risk for the supplier because cost overruns are charged to the customer. These types of contracts might be appropriate when it is impossible for either party to accuratlry assess costs in advance and there is a level of trust between partners. Such contracts need to be audited regularly to ensure all costs charged are reasonable and appropriate.
Cost-Based Contract – Type of purchasing contract where the price of goods or services is tied to the cost of key inputs or other economic factors, such as interest rates.
Incentives
Incentive arrangements and contracts that motivate desirable behavior can be particularly useful for CRM and SRM initiatives along with other collaborative arrangements between organizations.
Incentive Contract – A contract where the buyer and seller agree to a target cost maximum price. Cost savings below the target are shared between buyer and seller. If the actual cost exceeds the target cost, the cost overrun is shared between buyer and seller up to the maximum price.
Incentive Arrangements – Allows for the sharing of the cost responsibility between the buyer and seller. Incentives are incorporated into the contracts to motivate the supplier to improve its performance in areas such as quality, on-time delivery, and customer satisfaction. There are three elements of an incentive agreement: target cost, target profit, and sharing agreement.
Incentive agreements and contracts can be included in a trading partner agreement or negotiated separately. These arrangements align shared goals with individual motivations, resulting in collaborative effects. Self-centered motivations typically generate only self-centered effects, so it’s crucial to align incentives for successful collaboration.
When setting up incentive arrangements, organizations need to agree on a reasonable cost and profit margin for their goods or services. These targets should be challenging yet achievable. By doing so, both parties are encouraged to find ways to reduce costs and increase profits, leading to mutual benefits. If goals are met, the targets can be raised over time. Additionally, the organizations should establish how profits or excess costs will be divided between partners, and agree on a maximum price for any cost overruns that will be shared amongst them.