Contracts are legally binding agreements between at least 2 different legal entities named a buyer and a seller. The buyer wishes to buy certain goods or services from a seller. The seller, in return for the goods or services provided, expects monetary or other values to be paid to them.
When a buyer and seller agree to work together as mentioned above, both sides will have an expectation to receive some value from the other party. And both sides also have certain obligations to fulfill towards each other. A legally binding contract will help protect the rights of both sides by ensuring both sides fulfill their obligations. In case of any issues, any of the aggrieved sides can take legal recourse.
Elements of a legally binding contract
A contract is an elaborate document containing the detailed scope of work along with all other agreed terms and conditions, stating the rights and obligations of both sides.
A legally binding contract will have the following components:
- There must be an offer from one side. The offer must be genuine offer.
- There must be accepted from the other side. The acceptance must be a willing acceptance without any kind of pressure.
- There must be an equal exchange of values between both sides.
- Must be signed by authorized personnel.
- The work in the contract must be legally allowed work. There can’t be a legal contract for illegal work.
While all the above elements must be present in a legally binding contract, it is said that consideration is the most important factor, as that defines the benefits received by both sides. It is also said that the consideration must be win-win for both sides. Skills learned during their PMP certification training help managers get the best out of these legalities.
Contract Types
There are three broad categories of contracts as mentioned below:
- Fixed Price Contract (FP)
- Time and Material Contract (T&M)
- Cost Reimbursable Contract (CR)
Fixed Price Contract
Fixed Price contracts are used when the scope of work is clearly defined and the requirements are well understood. Once the scope is clearly defined, then it is expected that the seller will come up with a fixed price quotation for the agreed scope of work. The seller needs to understand the requirements and also all the associated risks which may occur during the project work while making a fixed prices quotation. Hence for a fixed prices contract the seller also needs to be very mature and capable.
Once agreed, it becomes a win-win for both sides. The buyer is assured of a fixed price to be paid once the defined scope of work is completed by the seller. The payments will be made based on delivering well-defined outcomes. The seller here assumes all the cost-related risks once agreed. The seller may lose money in this kind of contract, but at the same time, the seller may make a maximum profit also in this kind of contract if they can complete the work at less cost.
It will take solid maturity and clarity on both sides to come up with fixed-price contracts. Negotiation may take some time. Fixed price contracts once finalized, will use change requests for any kind of changes to be made in scope or any other terms and conditions.
There are 3 different flavors of fixed-price contracts as below:
- Firm Fixed Price Contract (FFP)
- Fixed Price with Incentive (FPIP)
- Fixed Price with Economic Price Adjustment (FP-EPA)
Time and Material Contract (T&M)
Time and Material contracts are very popular contract type which is used for regular purchases of standard items. Items may include augmenting temporary manpower for the project with well-defined skills and expertise levels. Item also includes standard materials which may be needed for consumption in the project.
In T&M contracts, the organization will select some preferred suppliers of such manpower and materials. The vendors will be selected based on their capabilities and experience. There will be a negotiated price (or rate) for such supplies. The final price paid will be for the amount of quantity of such resources consumed or purchased.
Managing T&M contracts is pretty simple. T&M contract uses both the flavors of fixed price and reimbursem*nt based on consumption.
Cost Reimbursable Contract (CR)
In cost reimbursable contract the buyer pays the actual cost incurred by the seller and an additional fee or profit. There are 2 components paid separately in this kind of contract. While the actual cost is reimbursed as per actual, the fee amount is somewhat decided upfront.
This kind of contract is used when the requirements are not clear. The team also does not have much clarity about the details of how the product will be developed. Hence in absence of clarity on all accounts, this becomes the best possible arrangement.
Cost reimbursable contracts are used for new research and development, and proof of concept developments which require immense innovation without a guarantee of the predicted outcome.
Following are some of the flavors of Cost-Reimbursable contracts.
- Cost plus a percentage of the cost (CPPC)
- Cost plus fixed fee (CPFF)
- Cost plus Incentive Fee (CPIF)
- Cost plus award fee (CPAF)
Cost plus contracts put all the risk on the buyer, as the seller is assured of all the actual costs plus some fees. The entire responsibility lies on the buyer. These contracts sometimes can be misused also. As the seller will not bother much about cost control, as they are assured of all actual costs. This requires the buyer to audit and micro-manage all the expenses.
Conclusion
The above contract types are used worldwide. Specific contract types can be used for specific kinds of purchases. Contracts have legal binding on both sides that are part of the contract.
