Monday, June 24, 2024
Monday, June 24, 2024
HomeContract ManagementContract: Definition and Types of Contracts

Contract: Definition and Types of Contracts

- Advertisement -
- Advertisement -
- Advertisement -
- Advertisement -

For the procurement of goods, works and services, we need to enter into contract with the supplier or contractor. Contracts are integral part of supply chain management. Knowingly or unknowingly, we enter into contracts to fulfill our day to day requirements also. The knowledge of contract is therefore necessary to procure the goods or services as per requirements of the organization. There are many type of contracts. Each contract undergoes a definite lifecycle. The management of each phase of contract lifecycle is called contract management. Let us first understand what the contracts are!

What is a Contract?

Contract is simply an agreement between two or more parties, which is legally enforceable by law. In other words, we can say that a contract is a promise made by someone to another person or party which is legally enforceable. The law is the law of the country where the contract is being executed.

Elements of a Contract

There are four basic elements of a contract, i.e., offer and acceptance, consideration, competent parties and legality of purpose. Let us discussed each element in detail.

Offer and Acceptance

To initiate a procurement, a proposal is issued by the procuring agency. The proposal may be in the form of ‘Notice inviting Tender (NIT)’, ‘Request for Proposal (RFP)’ or ‘Request for Quotation (RFQ)’. In response to this, the interested bidders submit their bids or quotations, which is legally termed as ‘Offer’ made by the second party (Bidder). Finally, one of the ‘Offers’ is accepted by the first party, i.e., the procuring agency, which is the last step in concluding a contract. Once the ‘Offer’ of second party (bidder) is accepted by the first party (procuring agency), it is legally enforceable upon the parties to fulfil their promises. The set of three steps, i.e., Proposal, Offer and Acceptance, is called an Agreement. Any agreement enforceable by law is called a ‘Contract’.

Counter- Offers

In the three step process as mentioned above, it is assumed that the “Offer” is “Accepted” by the first party, without any deviation. Thus the contract gets concluded without the need of any acknowledgement of the acceptance, from the second party (bidder). In case, the offer is accepted by the first party (procuring agency) with certain conditions, then it is called ‘Counter Offer’. In such a case the contract is not conclude automatically with the ‘Acceptance’. The bidder is not bound by his/ her promise or ‘Offer’ in this case. For a contract to get concluded in this situation, the ‘Counter Offer’ made by the first party (procuring organization) has to be accepted by the second party (bidder).

Consideration

Consideration is the promise to give something of value to a person or party in exchange of something of value by the another person or party. The value may be in terms of goods, services, works or money. So in case of procurement of goods, works or services, made by any procuring agency, the consideration is the amount of money equal to goods, works or services received. The consideration is a legal requirement, without which, a contract cannot be concluded.

Competent Parties

The parties entering into the contact should be competent enough to do so. A competent person means, he or she must be of legal age, he/ she must have mental capacity to enter into a contract knowingly. They must understand the nature of contract. A person who is minor, influenced by alcohol/ drugs, mentally ill, and/ or not having an authority to sign a contract is not competent to sign the contract.

Legality of Purpose

The performance of activities incorporated in the contract should not be prohibited by law. The contract should be in consistence with constitution of the country and should not be in violation of legal status or public policy.

Types of Contracts

The contracts are categorized as per their characteristics or purpose. Generally, the contracts are classified as per their pricing models. There are fixed price contracts as well as cost based contracts. In the fixed price contracts, the price of contract is fixed at the beginning, while in the cost based contracts, the price is determined on the basis of cost of the actual work performed. We will discuss the about each type of contract in detail.

Fixed Price Contracts

In these type of contracts, the price of the contract is fixed at the beginning and beyond the initially fixed price the procuring agency has no obligation for payment. In these type of contracts, most of the risk is on the supplier or contractor while the procuring organization is at the least risk.

There are several types of fixed price contract, some of which are discussed below in detail.

Firm- Fixed Price

In this type of contract, the price fixed initially does not change throughout the contract performance. In this contract, the maximum risk shifts on supplier or contractor and the procuring organization is at minimum risk.

Fixed Price Contract with Escalation

Prices of raw material, fuel, parts, etc. may fluctuate as per the market conditions. Therefore, price escalation clause may be incorporated in the contract according to which the price escalation is paid to supplier or contractor in addition to the price initially fixed. The method of determining escalation price is agreed at the beginning and incorporated in the contract.

Fixed Price with Incentives

In this type of contract, the seller or contractor receives some incentive or bonus for finishing the obligation early or achieving results above threshold. This extra ordinary performance may be either in the form of finishing the work early or delivering excellent quality work. This is a win- win situation for both the supplier and the procuring organization. The supplier or contractor gets incentive and the procuring agency is benefitted by extra ordinary performance done by the supplier or contractor and the risk of procuring agency is reduced in this case.

Fixed Price Contract with Price Adjustment

This is similar to ‘fixed price with price escalation’ with an exception that the price may be adjusted either upwards or downwards because of the market conditions. This type of contract is equally beneficial for both buyer and seller as it mitigates risk of both.

Cost Based Contracts

In these type of contracts, the contractor is paid the allowable cost incurred in performance of the contract plus additional amount as agreed between the parties. Some of the cast based contracts are discussed below.

Cost Reimbursement Contracts

This type of contract guarantees that the contractor, seller or service provider will be reimbursed the cost incurred in performing the work. The contractor, service provider or seller usually add a percentage of cost incurred as his/ her incentive for fulfilling the obligation under the contract. This type of contract is often referred to as ‘Cost Plus Contract’.

Cost Plus Fixed Fee Contract

In this contract, the contractor or service provider is paid the normal expenses of the project plus a fixed fee as agreed. The contractor or service provider do not have any incentive to control the cost of the project.

Cost Plus Incentive Fee Contract

The contractor is reimbursed the cost incurred in performing his/ her obligation under the contract plus incentive as agreed between the parties. In this type of contract, the contractor, seller of service provider’s profit will increase the more, the actual cost is below the targeted cost.

Some Other Type of Contracts

Lump- Sum Contract

This type of contract is very popular in construction industry. In this type of contract, the contractor quotes a lump- sum price for the entire work. This type of contract is used when the scope of work is well defined and it is fairly easy to estimate the price of the work to be done. In this type of contract, most of the risk is transferred on contractor as he or she be paid only a lump sum amount as agreed and will not be paid for any unforeseen expenditure.

Time Based Contract

This type of contract is employed when the scope and outcome of the work or service cannot be well defined. The risk of contractor or service provider is reduced in this type of contract because he or she will be paid for the manpower deployed and also reimbursed for the expenditure he or she has made. This type of contract is widely used in research projects or construction supervision services.

Time and Material Contract

The contractor is paid for the manpower and material in this type of contract. In this case the risk of contractor is minimum and the procuring agency assumes the maximum risk. The procuring agency also takes all the risk of scope change.

Item Rate Contract (Unit Price Contract)

This type of contract is popular in construction industry and is used when estimation of the items and quantities of work can be made easily. The contractor has to deliver the estimated quantities of the items mentioned in the contract. The contractor quotes unit price rates of the items which include overheads, taxes and other expanses. The quantities of the item are measured and the contractor is paid on that basis. In this type of contact, the risk pertaining to variation or delay due to hindrances, etc.  is assumed by the procuring organization.

Key Takeaway

(1) Contract is simply an agreement between two or more parties, which is legally enforceable by law.

(2) There are four basic elements of a contract, i.e., offer and acceptance, consideration, competent parties and legality of purpose.

(3) In fixed price contract, the maximum risk shifts on supplier or contractor and the procuring organization is at minimum risk.

(4) Fixed Price Contract with Price Adjustment is equally beneficial for both buyer and seller as it mitigates risk of both.

(5) In Cost Plus Fixed Fee Contract, the contractor or service provider do not have any incentive to control the cost of the project.

(6) Cost Plus Incentive Fee Contract motivates the contractor to save cost as he/ she gets incentive based on cost saving.

(7) Lump Sum contract is used when the scope of work is well defined and it is fairly easy to estimate the price of the work to be done.

(8) In Lump- Sum type of contract, most of the risk is transferred on contractor as he or she be paid only a lump sum amount as agreed and will not be paid for any unforeseen expenditure.

(9) Time Based Contract is employed when the scope and outcome of the work or service cannot be well defined.

(10) Time Based Contract is widely used in research projects or construction supervision services.

(11) In Item Rate Contact, the risk pertaining to variation or delay due to hindrances, etc. is assumed by the procuring organization.

(12) Each contract undergoes a lifecycle and the management each stage of contract lifecycle is called contract management.

- Advertisement -
Rajesh Pant
Rajesh Panthttps://managemententhusiast.com
My name is Rajesh Pant. I am M. Tech. (Civil Engineering) and M. B. A. (Infrastructure Management). I have gained knowledge of contract management, procurement & project management while I handled various infrastructure projects as Executive Engineer/ Procurement & Contract Management Expert in Govt. Sector. I also have exposure of handling projects financed by multi-lateral organizations like the World Bank Projects. During my MBA studies I developed interest in management concepts.
- Advertisment -

Most Popular