Procurement is a process of acquiring goods from supplier or services from service provider. It can be a complex process and the degree of complexity arises from the requirements of different regulations, engaging professional consultants, achieving value for money, demonstrate accountability, maintain relationships and achieve specific business objective.
From the customer perspective what matters is the COST, QUALITY and TIME. They want the product of highest quality, lowest cost and the shortest time. In the majority of the time it is not possible to achieve all these, so compromise is needed. However, if those 3 factors are kept in balance then the equal weight can be given to these factors. If one of the factors must take precedence, then at least one of the other factors will suffer and carry less emphasis.
If quality is of the importance, then the adequate time must be given to the design and specification to be perfected. If the speed is important, then the quality and cost may suffer. If the lowest cost is the priority, time and quality will suffer.
With the right management, all these factors can be balanced and adequately controlled. The procurement manager need to be instructed on the priorities and implications outlined.
There are 3 different procurement routes that may be taken but different route will result in different conclusion.
Figure below presents the different route categories.
Source: Hakett M., 2016, "The Aqua Group Guide to procurement, tendering and contract administration", Wiley Backwell
A key decision when selecting a procurement strategy lies with the manner in which each design in progressed. Each procurement route have different quality, time and cost scenario.
The weight given to each factor should be decided at the briefing process and then decide on the appropriate route. Sometimes overly prescriptive briefs can cause limitations as well as unnecessary high standards. Delays in making decisions, often changes, poor communication, conflicting objectives and issue of design information can further slow the process and create barriers. But foregoing risks must be determined during the procurement strategy. There are also different contracts available for different strategy, but the selection of contract should be a secondary task.
Other considerations
Cost, quality and time are not the only factors that need to be considered when selecting an appropriate procurement strategy. There could be other risks and accountability indicators, regulations that may influence the decision. In majority of design projects, Health and Safety is very important. Some companies may want to clarify the responsibilities and obligations of each part. These indirect influences may affect the type of the procurement strategy that is taken. The nature of the project, its management, selection of suppliers, high risk activities, regulations and requirements will play crucial role.
Generally, regulations are mandatory, but sufficient to any procurement strategy.
The risk
It is important to establish the attitude to risk at the earliest opportunity. If customer is prepared to take larger risks, the contract will have much greater flexibility to devise suitable strategy.
Accountability is closely related to risk and decisions at the very early stages of the project may have a significant effect on the procurement strategy.
Entering into a contract
Having decided which procurement route is the best the process of entering into a contract may be divided into 3 parts:
Deciding on the type of contract with particular terms and conditions,
Selecting the supplier,
Establishing the contract price.
The type of contract
The type of contract is generally chosen by the customer and it will be inherently linked to the procurement strategy. The choice should be made as early as possible to prepare documentation. Prices should be established before tendering starts. In negotiation contracts the price decision can be delayed.
Selection of the contractor
The purpose of any tendering procedure is to select a suitable contractor, at time appropriate to circumstances, and to obtain from him in appropriate time acceptable offer under which contract can be let. So the purpose of tendering is to select a contractor and obtaining an offer to carry out works. The tendering is not dependent on the type of contract. Contracting arrangements are concerned with the type of contract with the obligations, rights and liabilities. Contractor may be selected based on drawings and quantities or single negotiations.
Establishing price and time
Traditionally it has been assumed that tendering is concerned with establishing a contractor with a lowest price. But price and time may not only be the only consideration.Tendering offer is not just a price but a standard of quality and time.
The dynamics of tendering
Tendering creates dynamic situations. There are so many factors to consider that we cannot rely of a single procedure, but think about it on a form of 'structure and requirements'. Tendering may comprise procedures of open tendering, single-stage selective tendering, two-stage selective tendering, selective tendering and negotiation.
Fixed price and cost reimbursement
These are the two methods of making payment, but very rarely a contract applies only one of those methods and often these are combined.
Fixed price items are the prices paid for on the basis of predetermined estimate including a level of risk. The tendered price is paid by the employer irrespective of costs incurred by the supplier.
Fixed price is the unit rate, a section of work or equally to a whole contract. Contract may consist of multiple units of rates or a single lump of sum. A fixed price contract needs to have a finite sum allocated at the beginning of the contract and the price is fixed. Only the quantity of work is unknown and work is measured as is done.
Cost reimbursement payment is not based on predetermined rate of costs. A contractor is paid what the job actually cost him within the limits of contractual arrangements. It would involve a rule of how the cost is presented to a customer. This is often prescribed as 'open book' approach. If the actual cost is higher then the predetermined cost, the customer pays the additional costs. If the costs are less, then the customer gains from the savings.
Contract application
Once we have established the costing terms, these generally consist of the following:
Preliminaries - list of sums to be paid - fixed price
Unit costs - fixed price
Defined or undefined provisional sums for work anticipated - cost reimbursement
Overheads and profits - sometimes expressed as one sum and sometimes as percentage
The supplier or contractor will be held to this commitment. Profits and overheads need to be reviewed in the event of variations. Generally the contractor obligations are fixed in respect to those things which are known. Generally there are cost reimbursements for labour, materials or plant which also include fixed prices. These can fluctuate but percentage is normally fixed.
The element of cost reimbursement may come under fixed price contracts involves the fluctuations for labour and materials costs. When fluctuations are included in the contract they include an increase or decrease of a basic costs based on the fluctuations in the marketplace.
Having determined fixed costs and cost reimbursements in a contract is not the end of the matter. In fixed price contracts, contractors take risks on prices being wrong, whilst in the cost reimbursement parts the customer is taking the risks. It may be desired that the risk of the estimate should be split between the two parties and allow for it in the contract. A target cost contract may be employed.
When assessing the risks the customer's financial position, time requirement for project, corporate restrictions and the work available in the marketplace should be considered. Customer may have defined budget for the project and time to obtain fixed price quotations and the risks should be minimised. When time is important, cost reimbursement could be considered. The customer need to be aware of the balance between the two methods.
For the supplier's position their financial strengths, their acceptable risk level, the extend to which work is defined and the work available on the market needs to be considered.
Generally when the supplier is asked to take risks, they will add a 'buffer' to their fixed price to cover the eventuality of the risks arising. Sometimes the supplier may not be prepared to take a risk and refuse the tender. Normally a supplier with better financial position is able to take more risks and the level of risk is a commercial decision.
When it is impossible to define the work clearly, reimbursements can be very beneficial. Attempting a fix price may be carrying a substantial level of risk. When new designs are in question it may be more suitable to based pricing based on reimbursement structure. Additionally, the market conditions may influence the suppliers attitude to tendering. When the market is depressed the supplier may want to take more risk within the fixed price.
Reimbursement costs are more widely applied when the time is of importance. When the time is essential and it is not possible to define the details of the works this method of costing can be used.
Comparisons between the two systems are presented in figure below.
Source: Hakett M., 2016, "The Aqua Group Guide to procurement, tendering and contract administration", Wiley Backwell
We can see that a considerable time savings can be achieved using the cost reimbursement contracts. So, when there is a sufficient time to carry out work this will determine the type of contract, however majority of a large project contracts are based on both methods: fixed price and cost reimbursement. Customers are prepared to take more financial risks to pursue shorter procurement times and lower prices. "Open book" arrangements often allow for both parties achieving the best value, share risks and benefits.
The benefits
Advanced procurement strategies allow for reduction of operating costs, drive operational efficacy, allow for cost savings and greater resiliency. Leverage information across the supply networks allow for bias-free insights, increase supply chain flexibility, responsiveness and allow for real-time changes in the negotiation processes. Suitable tendering and procurement processes allow for supply chain responsibility, supplier diversity, managing the customer and supplier expectations and increase the speed of value.
A fixed price contract is is a contractual agreement with the predetermined value for goods and services provided. It sets the terms of project and establishes price for goods and services. It outlines exactly what is required and the customer's obligation for a fixed price. These are useful when a project scope is clearly determined and it gives each party certainty as to what will occur without special conditions of a contract. This type of contract may keep prices of materials and it provides the buyer security in knowing what they will pay rather then estimates. These are particularly useful when the price is easily accessible and simplify the process of contracting. It can benefit each party and provide the peace of mind about the costs expectations.
A cost reimbursement contract is an agreement between two parties to provide payment for allowable costs incurred by the other party. The final pricing of the deal is determined later based on the deal and the actual costs it took to complete the project. This can create multiple challenges for managing the contracts as we need to track complex information, estimates, project dates or renewals. The final pricing is determined once the project is finished or on the date set in the contract. Generally the supplier provides the costs estimates which helps to determine the total budget for the project. They exist to protect the seller and their profit margins as the cost burden is shifted on the customer. It gives parties much more flexibility as they can choose shared costs, offer incentives, reduce total costs etc.
Bibliography:
IBM, "Transform your procurement operations", accessed from https://www.ibm.com/consulting/procurement?utm_content=SRCWW&p1=Search&p4=43700075186240315&p5=e&gclid=EAIaIQobChMIzOTN7JPP_gIVysLtCh3VgQ9wEAAYASAAEgLNTvD_BwE&gclsrc=aw.ds, accessed on 29/04/2023
Hakett M., 2016, "The Aqua Group Guide to procurement, tendering and contract administration", Wiley Backwell
Ironclad, "Managing your cost reimbursement contracts", accessed from https://ironcladapp.com/journal/contracts/cost-reimbursement-contracts/#:~:text=A%20cost%2Dreimbursement%20contract%20is,took%20to%20complete%20a%20project. accessed on 29/04/2023
Ironclad, "What is fixed price contract?", accessed from https://ironcladapp.com/journal/contracts/what-is-a-fixed-price-contract/#:~:text=A%20fixed%2Dprice%20contract%20is,obligations%20for%20a%20firm%20price. accessed on 29/04/2023
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