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Why and when do companies need contracts in purchasing management? What are the main contract types used by companies? What are the advantages and risks of each contract type? Would you like to understand contract management in corporations? If yes, keep watching. Get better marks, be ready for job interviews, and excel in work meetings. We are here to help you! Subscribe Americo e-Learning! Welcome to supply chain management lessons my name is Americo Cunha! Learn fast, solve problems, and make good decisions! In this lesson, we will be exploring 3 questions about contracts in purchasing management. Why do companies need contracts? When is a contract is needed or not? What are the most common contracts? What are advantages and risk of each contract type? How to choose the best contract type for the company’s needs? Let's get started! Why do companies need contracts? Well, sometimes they need, sometimes they don't. A contract is better when: the company needs a continuous supply, of products with complex requirements, of customized solution, with significant information sharing for a medium/long term commercial relationship. When a contract is not required: in discrete or one-time purchasing to fulfill an occasional short-term need in a simple buyer-seller transaction when there is no process integration A contract is a good tool to define what is being bought and its cost operations processes for ordering, shipping, and receiving to define quality and acceptance criteria to establishes payment and warranty procedures With contracts, companies manage 1) information flow: the contract establishes the communication process Who sends/receives information, at what time in what form. Also, how communication systems will be integrated, what information will be transferred through electronic data interfaces (EDI) 2) the goods flow: the contract defines defines how materials will be ordered, how materials will be ordered, transported, delivered, received, and accepted 3) In the Financial flow: contracts describe how and when payments will be made. 4) commercial relationship, contracts specify the point of contact who is responsible for what and the escalation procedure in case of problems What are the main contract types companies use? There are 3 main contract types: fixed price, time and materials, and cost based contracts Almost all purchasing contracts are based on some form of pricing mechanism and can be categorized as a variation of two main types: fixed-price or cost-based Fixed-price is a contract in which the price of the product or service is fixed during the contract duration. In this contracts, buyer and seller should know very well the specifications and therefore, the cost can be better estimated In a cost-based contract, the buyer agrees to reimburse the supplier for the expenses incurred and, of course, plus a dollar amount of profit. To protect against cost overruns, some companies define the maximum cost the supplier cannot exceed. In Time & Material (T&M) contract, cost unit rates are predetermined, but the labour and material quantity can vary. Therefore, the total cost is not fixed although unit cost is predetermined. It is a kind of hybrid contract. In this small example, the brick and the labor rate have a fixed cost, the total price will depend on the amount of the material used and hours worked. Fixed-price contracts may have problems to handle changes and quality assurance. There are small modifications that can be implemented to reduce the most common risk. The main varieties are intended to provide provide formal mechanisms to change prices and to provide incentives for quality. The major challenge is cost-based contracts is the risk of cost overrun. Sometimes is nice to change some aspects to motivate contractors to keep the costs low. Financial incentives are usually very effective. What are the advantages and risk each contract type? Cost overrun The risk that the cost exceeds the contract budget estimated cost, or target value, is much higher in cost-based To mitigate the risk, the buyer should put additional effort in the contract administration, expenses control, maybe include saving incentives for the supplier. Low quality in fixed-price contracts the potential for low quality is higher Because the price is fixed, the vendor/contractor may be forced to reduce costs what may affect product/project quality. To mitigate this risk, the buyer should have well know specifications and include quality standards and expected performance in the contract. Depending on the supply condition, one contract type may be more suitable than the other. For instance, every time that there is a high level of uncertainty, it is almost impossible to develop detail specifications. therefore fixed-price contract is not recommended. Long-term contracts also bring changes naturally due to its duration. Therefore fixed-price should be avoided. In case the company has an in-depth knowledge and experience about the product, and are able to develop very well detailed specs, fixed-price is a good alternative. On the other hand, the cost-based contract can be more suitable when there are high uncertainty and long durations. The Time and Materials contracts are an intermediate solution that combines elements of fixed-price and cost-based. It has fixed-price for work-units and materials, but also accommodate changes in the scope and workload. In this video, we presented the main concepts of contract management. To check your learning, try to answer the following questions? Why and when do companies need contracts? What are the main contract types used by companies? What are the advantages and risks of each contract type? What are the best scenarios to use fixed-price or cost based contract? [Music] We work hard to help you to get better marks be prepared for job interviews and excel in work meetings you can send your questions in the comment area below I'll be pleased to answer all of them Thanks for watching and don't forget to subscribe Americo e-learning