What are procurement contracts?
Procurement contracts are commercial agreements for the sale of B2B (business to business) products or services. The good or service being sold is something that the buyer uses for its own business. It can be anything from a raw ingredient for a restaurant’s meals, to a business software application that a multinational corporation uses to manage its payroll, organize competitive intelligence, or create product archetypes.
Given the sheer number of different inputs and tools that businesses need — you might purchase goods or parts, computer equipment, software licenses, office space, travel accommodations, and food, to name just a few — a central part of doing business is hiring other businesses. You need to know that you can rely on your vendors.
Vendor relationships based on trust are important for two key reasons. One is the continuity of your operations, including your supply chain. The other is your own business’s reputation.
As far as regulators and consumers are concerned, your reputation is only as good as those of your business partners. You need to Know Your Vendor, and that doesn’t stop at conducting due diligence before signing the contract. Compliance with regulations dictates that you maintain an understanding of who your suppliers are and how they do business. It’s your responsibility as a business leader to stay aware of problematic practices on the part of your suppliers. That starts by setting expectations in the contract regarding the standards you expect your vendors to uphold.
Setting out clear terms and conditions up front can also help to prevent scope creep — the gradual accumulation of extraneous add-ons and side projects that can eventually threaten to derail a project, and with it, the business relationship. By proactively outlining the goal of the agreement, what each party expects from the other, and when those commitments will be considered fulfilled, buyers and sellers can both gain peace of mind.
Procurement contracts can range from purchase orders, to ongoing agreements with independent contractors who supply labor, to general service agreements for one-time deals, to auto-renewing software licenses. While a deal can take on virtually any form that the parties find beneficial, there are some deal structures that have emerged as the most popular.
Here are three of the most common types of procurement contracts:
In a fixed-price contract, the payment amount doesn’t change to accommodate fluctuations in inputs that the supplier might experience when providing the contracted goods or services. If the vendor has to spend more time or pay more for raw materials than they originally predicted, it’s up to them to cover those costs. Accordingly, it’s up to the supplier to accurately anticipate their costs before setting prices, as they can’t ask for more money if they under-budgeted.
The buyer benefits from the predictability of their payments over time. However, the advantage for the seller is that their profits aren’t constrained by their cost structure.
A common example of a fixed-price contract is a software license from a technology vendor. Buyers typically pay a fixed monthly or annual price in recurring installments, with the price determined in advance based on an input such as the number of people who will be using the software. The supplier absorbs any cost overruns related to maintaining and providing the SaaS platform.
These are also known as cost-plus contracts. There are two components to the price. First, the buyer reimburses the seller for the cost of goods sold (“COGS”), including labor and raw materials.
Second, the buyer pays an additional fee to the seller; the fee goes toward the vendor’s general operating costs and serves as the source of its profits. This fee might be a fixed percentage of the total COGS, or it can be based on a predetermined incentive structure. For example, an incentive plan might offer higher payments if the vendor completes a project under budget or ahead of schedule.
The contract should define all rates, allowable expenses, and the maximum amount the seller can spend. A cost-reimbursable contract ensures that the vendor makes some money for completing a project (rather than only breaking even or worse, losing money), while the buyer pays only for what they actually get.
An example of a cost-plus contract could be a construction project. The construction company charges the buyer for the cost of raw materials such as lumber and concrete. They could then receive a flat fee, or under an incentive contract, alternatively, the company might receive higher payments for finishing construction a month early or finding a way to save money on labor or raw inputs.
This type of contract also has two components to the price. First, the buyer reimburses the seller for any materials they end up using while providing the goods or services. Second, the buyer pays a predetermined wage, typically on an hourly or daily basis. Buyers don’t pay for work that isn’t done, and sellers are reimbursed for all of the work that they complete.
A familiar example of a time-and-materials contract is a law firm billing clients by the hour. Lawyers generally charge hourly rates based on the amount of time they spend each month working on matters for a particular client. They add business-related expenses they’ve incurred in the process, ranging from printing costs to travel and meals.
Given that the terms of the business relationship are defined in the contract, a key part of procurement management is contract management. The vendor contract is where you’ll set out expectations, and it’s your primary means of managing the risk inherent in, and keeping track of, your vendor relationships.
When negotiating supplier agreements, you first need to determine what’s standard for your business, whether it’s your expectations regarding cost reimbursement or even your decision to default to using your own standard agreement as opposed to the vendor’s agreement. If a vendor wants or needs to deviate from that standard, it’s up to you to determine your limits. Establish in advance what you can and will accommodate, and past what threshold you will walk away from negotiation.
Having established standard documents and procedures for your business, you can contract the seller to provide the agreed-upon goods and services within a set timeframe. The contract should lay out clear cost and fulfillment parameters for the provider. For a finite engagement, the project team should know exactly how long they have to complete the project and what their budget is. Project managers will benefit from having concrete goals and limits on which to base their targets and milestones.
Businesses today can easily have dozens or even hundreds of vendor contracts in place at any given time. That scale entails a potentially vast range of pricing structures, fees and rates, timelines for renewal of ongoing services and licenses, and other terms to track across a portfolio of vendor agreements. It’s vital for today’s business leaders to have all of that information at their fingertips, easily searchable, understandable, and presentable.
As a result, manual contract management processes are simply insufficient for procurement teams operating in a global marketplace. In order to move at the speed of business, you need a solution that’s fast, intelligent, and dependable.
That’s where contract intelligence comes in.
Contract intelligence is the application of artificial intelligence to contract management. A contract management platform built on AI can quickly and reliably recognize a wide range of common fields and terms, deliver automated alerts regarding upcoming deadlines, and generate reports on what’s in your contracts.
AI can also streamline the procurement process by making it fast and easy to create new contracts. Cutting-edge natural language processing algorithms recognize context in your existing documents and write as well as a skilled human writer, enabling the automated creation of new contract templates based on your favored language.
Time saved manually sorting through and drafting documents is time that your procurement team can spend focusing on analysis and strategic decisions.
Can your procurement team afford not to have the smartest, fastest contract management solution on the market?
Evisort’s AI can streamline your procurement team’s contract management processes and put the information you need about your vendors front and center for your leadership team. Ready to learn more? Schedule a demo today!