Considerations in Procurement: Contract Types and Assigning Risk

Peter Skrzypczak, MSM

December 24^th, 2006

Abstract:

In this paper we look at the different types of contracts as classified by differing institutions and the relative ease or difficulty in managing them. We examine these in the light of procurement strategies and tactics. We also briefly look at managing risk relative to each procurement approach.

Contract Types Hierarchies:

Pretext: In the last Discussion Board Posting (Skrzypczak, P., 2006, October) “Ancillary Service Procurement: Strategy for Contracts Case Study” we reviewed the legal requirements and definitions for legally enforceable contracts. These differ greatly from some of Kerzner’s breakdown. As such I will attempt to address the two (among many) types of contract type hierarchies. Aristotelian logic leads to this type of informational organization, and while it is over 2,500 years old (Aristotle, 350 B.C.E.), it is often still applied, even thought the underlying systems may not at all be modeled well this way [“network models” being one relevant exception].

The reason for explaining the two types of contracts is done because while, in theory, Kerzner may have some valid points to looking at things a certain way to make them more easily manageable -- in the final analysis, if one goes to court to legally enforce a contract, the judge is more likely going to go along with Black’s Law dictionary and the contract law approved by the [American Bar Association] ABA, not some [Master of Science in Management] MSM program. In court, the harsh reality is that contract specific terms can often go into semantically lengthy arguments for which the legal costs of enforcing the terms may easily outweigh the economic value of enforcing the terms. Thus a healthy business decision is made not to litigate, even though the terms are stated in the litigant’s favor, and even where the litigant is “right”. This reality departs from Kerzner (2006) theory. and it is worthy of note.

Facing that hard reality is important in business to prevent severe disappointment and lack of income at a later time. It also may point to the overall informational models that might be used in data systems and the legal department, with which the Project Manager will have to reach an agreement. Citing an online presentation or a book by Kerzner (2006) (who in his section on Quality Management contradicts himself, and famous prize-winning Philip Crosby, d. 2001 [see Appendix A]) will not make bring the money to “the bottom line”. If anything impedes Sales, my experience tells me that it is excised faster than a tumor, and that includes Management Theory.

ABA’s ideas on “Types of Contracts”

“The law recognizes contracts that arise in a number of different ways:

A bilateral contract is the type of agreement most people think of as a traditional contract -- a mutual exchange of promises among the parties. In a bilateral contract, each party may be considered as both making a promise, and being the beneficiary of a promise.

A unilateral contract is one in which the offer requests performance rather than a promise from the person accepting the offer. A unilateral contract is formed when the requested act is complete. A classic example of a unilateral contract is a "reward" advertisement, offering payment of money in exchange for information or the return of something of value.

An express contract is formed by explicit written or spoken language, expressing the agreement and its terms.

An implied contract is formed by behavior of the parties that clearly shows an intent to enter into an agreement, even if no obvious offer and/or acceptance were clearly expressed in words or writing.” (Findlaw, 2006b)

As for the ABA-defined contract types, having an express, unilateral contract might be best to minimize risk as the terms are written down in clear language and the quid pro quo of “service/product for fee” is spelled out. While this might take more time in negotiation, it provides a solid reference point as the project progresses to keep all parties within the project guidelines and definition, reducing the likelihood of budget inflation and schedule slippage due to changes in scope or quality performance of work, making it the easiest ABA-defined type of contract to manage.

Common Business Ideas of “Types of Contracts” (per Kerzner, 1998), and how complicated or simple to manage:

CTU categorizes contracts accordingly, per commonly available guideline knowledge in business:

1. “Fixed price, or lump sum”
These are used where “cost is the largest concern”, and involve the least internal resources in terms of negotiation. (CTU, 2006b) There is not internal cost accounting that must be done to calculate payment. It is the easiest contract type to manage due to lack of complexity. However, depending upon whether this is an [ABA-type] bilateral contract or a unilateral contract, there may be necessarily the tracking of certain “deliverables” to make ongoing payments as partial contract objectives are fulfilled. We would hope that an express contract would be used to define performance terms. A “variation” is where there is a “non-fixed” part of the contract. [see #5, below]

2. “Cost plus fixed fee, e.g., % of the cost for a fee” (CTU, 2006b)
In this case the contract payment is calculated by tracking costs internally, looking at the receipts, and then, using internal accounting resources, calculate payment based upon the tracked costs. This type of contract requires more internal data management than a fixed price contract. It has the advantage, however, of limiting costs to a reasonable profit margin that may be more competitive. On example of where this type of contract might be very useful would be where a third party is acting as agent for a customer, and whose fee is incentive based upon keeping costs below a certain threshold.

3. “Guaranteed Maximum Share Savings Contract” (CTU, 2006b)
In this type of contract, all the work must be done as promised, and there is a maximum profit that is allowed the vendor. In this way, if the market conditions change or the base costs change, the vendor can perform the contract, with the customer being assured and knowing of a reasonable payment for the vendor’s services. It also exposes internal capital acquisition real costs as well as labor costs for cost accounting the project, which might be relevant if FASB [Financial Accounting Standards Board] guidelines apply to their business [which is true for all companies that trade their securities in a US stock exchange]. This is the most complex to manage due to the tracking of a multitude of moving parts.

4. “Fixed Price with incentive fee” (CTU, 2006b)
To iterate, this is used where cost (not time) is the largest concern, but also includes a variable amount to address the time factor. Again, the easiest to negotiate since costs are fixed, and the fairly easy to monitor, since there is not internal accounting of costs necessary, and the only thing that must be tracked for cost calculation is whether or not certain goals linked to the incentive payments have been met.

5. “Cost plus incentive fee” (CTU, 2006b)
This is the same as the “standard” cost plus, but with a fee for meeting certain timelines/goals to address schedule creep concerns.

Incentive based contracts help to allocate risk in terms of schedule slippage by providing financial incentives as insurance [“carrot”] while legal business remedies can be used to provide more incentives [“stick”]. Incentives can also be applied to keeping within original budget estimates to contain costs, and the risk of budget inflation. As mentioned above, legal remedies can be so costly that that does not make practical sense to use them as a core component of a good risk management program.

Cost plus contracts alone do not help to reduce budget inflation risks. Since the more an item is paid for, the more the second-party vendor receives, there is no incentive to select the lower cost supplier, since it reduces the second-party vendor’s commission.

Guaranteed Maximum Share Savings Contracts suffer a similar problem in this particular case study involving ACME™.

Executive Discussion

Let us consider the case that we that we are simply putting in place a software tool for the IT department. We are not building a skyscraper and hotel complex, nor are we implementing an entire defense grid for the military or building a hazardous waste containment facility on the Columbia River. So the increments of cost inflation and detail are not going to be as significant here, and a cost plus type of contract is not as necessary. In other words, “Let’s not make a big deal out of this”. The PMO supervisor will be looking at how much something simple is made unnecessarily complex and how smoothly the PMO does business. Inveigling all sorts of internal resources is not going to be looked upon smilingly, and may be seen as attempt to wrest power from the company. It also does not address the biggest risk – getting this to the field as soon and as cleanly as possible. If this is done poorly and slowly, other projects that will be using the tool will suffer accordingly. So “high-stakes”, “high-visibility” projects require high quality resources and excellent risk management.

Because of the importance of meeting certain timelines (“90 day”, and “60 day” deliverables) an incentivized cost structure needs to be used. This means that Kerzner’s’ fixed price plus variable incentive or cost plus incentive contract model are most applicable.

To narrow down further, since the organization does not have (nor want) a large contract management (legal) team and the project is not allotted internal accounting resources, and there is not a lot of time for negotiation (timelines, as previously stated), the fixed price type of contract applies, since negotiation into each task and part may well exceed any savings gained by using a more complex cost plus model.

As posted previously:

“Many software vendors have “partner programs” that provide the technical and business savvy to deliver these services for a fixed price, in a fixed price unilateral contract. As time is an important element here, we probably do not want to go into an RFP/RFQ process for the ancillary services, but we want to withhold payment until services are properly rendered as a security that work will be done as promised.” (Skrzypczak, 2006, October) Get solid references.

In one area of the project, however, i.e.:

“in the expert level training, we may wish to negotiate for a fixed base price with additional units that can be purchased at a guaranteed price and within a certain delivery time. Here we want to make sure that the knowledge transfer occurs, and since humans learns at variable rates, we need a variable rate cost structure to match with it. Standard rates for trainers include not only the cost of services, but also for reasonable travel and accommodations [including meals] – this is usually handled with a “cap” for these expenses. While we would like to keep costs down to a minimum, we also want to address the “human factors” with the good instructors.” (Skrzypczak, 2006, October)