For many years Buyers have used ‘fixed price’ contracts – a contract that stipulates the final price regardless of the outcome.
There are a couple of common reasons why buyers use them. The first is to move the risk of the contract going over budget to the supplier. The second is to encourage the supplier to act appropriately and encourage them to complete the work under budget if possible.
While the buyer might think this represents smart procurement, this might not be the reality.
Suppliers are very familiar with fixed price contracts and recognise the risk being moved onto them. Their response is to modify their submitted price to include a contingency fund (price + contingency = submitted price).
In moving to a fixed price commercial model, the buyer is making a statement that they believe the contract has a high probability of going over the initial estimates and hence want to move the risk of this occurring onto the supplier. It is the act of pre-empting risk which pushes the supplier to include a contingency in the price.
Horror stories abound about suppliers under-estimating requirements and ending up absorbing much higher costs than expected when delivering the contract. While these stories are used as the justification for fixed price contracts, in reality this occurs less often than most believe.
If it was a common occurrence, suppliers would either go out of business due to additional losses, or refuse to accept a fixed price contract. The reality is that to deliver the requirement, the supplier generally gets their initial estimates correct or consumes a small percent of their contingency fund.
Here’s the issue…
From the suppliers’ perspective, a fixed price contract is a risk/reward model, and regardless if they deliver the contract for the stated cost or less, they invoice for the full amount. Here is where we hit an issue – assuming that in delivering the requirement the supplier has not consumed all of their contingency fund how does the supplier invoice for the full amount?
There are a couple of options here.
- Invoice based on Stated Costs: The buyer and supplier agree to invoice based on stated costs i.e. phase 1 will be invoiced for X, phase 2 for Y, etc. This will enable the supplier to invoice for the agreed amount. The issue for the buyer is lack of detail behind the invoice and being unable to quantify what has been purchased if challenge
- Itemised Invoices: The supplier provides itemised invoices, enabling the buyer to assure the business of what has been procured. The fixed price was justified based on the contract requiring a certain number of assets to deliver it (an asset could be Personnel, Resources, Time or Goods).
Yet in delivering the contract, the supplier has not utilised their full contingency fund and therefore not required all the assets predicted. This results in the supplier submitting invoices that include assets that were not actually required by the buyer, but that the supplier has to include in order to ensure numbers add up to the full amount. This could be interpreted as an act of embezzlement.
“Embezzlement is an act of dishonestly withholding assets for the purpose of conversion (theft) of such assets, by one or more persons to whom the assets were entrusted”
Either the buyer naively expects that the contract requires the supplier to utilise their full contingency fund, or is endorsing the ’embezzlement’ by paying for assets they know have never been delivered!
Assuming the buyer knows a contingency has been added, when they agree the fixed price, not only were they agreeing to the predicted costs but agreeing to pay the contingency fund too. In effect they have guaranteed to pay more than is required – a great way to reduce procurement savings.
We are not actually stating fixed price contracts are embezzlement but it makes one wonder. Fixed price contracts introduce supplier risk, more often than not to the detriment of the buyer. If buyers could encourage suppliers to collaborate and deliver the contract under budget for mutual financial benefit, it might be a better solution.
A nice theory, but up until now, a fixed price contract has really been the only viable option. However, there is a new option for both parties to use – The POD Model for Supplier Innovation. The model enables a buyer to revert back to a standard price based contract, the supplier is only paid for what it takes to deliver the contract and the supplier is incentivised to deliver the contract for less to achieve higher profits. This approach results in higher procurement savings, the right supplier attitude and clarity on invoicing.
So, it is maybe now time to review the use of Fixed Price Contracts?
POD Procurement created The POD Model and provides consulting and training on its implementation. The POD Model is free to use and can be found on the CIPS knowledge website. For additional information please contact [email protected]