Contracting and procurement

Developed by Hildur Gudmundsdottir

Abstract

This article will present a review of the tendering phase and contract management of project procurement management. Decision factors and methods for a company's procurement division when selecting a supplier and negotiating a contract will be presented. All companies have to make a decision whether to produce in-house or outsource their goods or services. If companies are lacking capacity, skills or knowledge, other alternatives are explored. One alternative, outsourcing, and an in-house production will be weighed, introducing risk and benefits of both methods. When the needs have been determined a supplier is chosen. Multiple factors should be considered when selecting a supplier and selection criteria is prepared in procurement documents. When all requirements have been stated and suppliers evaluated, the company must decide between a pool of sellers, which they seek offers from, or choose to negotiate with a given seller. When the supplier has been chosen, a contract must be designed with some main objectives. When negotiating a contract, the main things to consider are to ensure that the buyer is able to meet their customers' demand and propose a system where the supplier and the buyer share risks and cost. The article will first introduce briefly the definition of procurement and contracting separately, and then explain the relationship between the two. The article will then be divided into five main parts; defining the problem, defining the buyers' needs, determining the qualification of a supplier, choosing a supplier, and finally the contract terms.

Contracting and Procurement

Contracting

The definition of contracting is an agreement between two or more parties, especially one that is written and enforceable by law. Contract management involves creating a contract, negotiating terms and conditions, compliance, execution and analyzation. In project procurement management contracts are made between the buyer and the seller. It is a document stating that the seller will provide some value in return for compensation from the buyer.

Procurement

Procurement is the acquisition of goods, services or works from external sources. The goal of procurement management is to identify a supplier to procure goods or services for a specific company. Project procurement management spans a wide range and is present throughout the whole project process.

Contracting and Procurement

Figure 1: Five steps of Contracting and Procurement that will be demonstrated.

All companies have to make a decision to produce in-house, or outsource the production. If the benefits for outsourcing exceed the benefits of producing in-house, companies must find a supplier that is reliable and maintains a certain standard. Project Procurement Management includes all processes needed to deliver goods or services from outside the project team as well as the development of contracts issued with the supplier. In this article the scope of the buyer will be explored. The five steps that will be explored further in the following article are presented in Figure 1.

Defining the Problem

The first step to the tendering phase of procurement is to determine how much should the company itself produce and what is cheaper and/or justifiable to outsource. The first step is to define which problem is present. If companies decide to produce in-house, they might need raw materials and equipment to produce. If companies lack capacity, if production is expensive, if they do not have the people, skills, or knowledge to execute, other alternatives should be investigated. One of the options is outsourcing. Outsourcing is when a company requests goods or services from an outside party. Advantages and risks of both producing in-house and outsourcing need to be evaluated, and an optimized plan developed for make/buy decisions. Justifications should be presented for outsourcing, and a production plan for in-house production. A meaningful procurement strategy should be developed, with the following factors considered: .

• products
• services
• technologies
• financial plan
• global presence
• geopolitical and economic risks
• growth plans
• competition
• customer satisfaction
• corporate social responsibility
• regulatory and political environment
• employee growth and satisfaction.

All available information about these factors should be gathered through company strategic and operational plans, annual reports and executive management input. The procurement strategy will state all in-house production and outsourcing decisions, and both have different benefits and risks.

These are stated here below:

In-house Production

Benefits

The benefits of in-house production are:

• Quality Control: Companies have more control over their production process and a more agile environment where changes and improvements to the process are easier done.
• Production Control: Companies can keep track of variances and make changes to the scale of production faster and easier.
• Cost tracking: The cost of manufacturing is transparent and can be tracked easily. It also eliminates the profit fee added by the supplier, as well as delivery costs.
• Knowledge Protection: When all development and production takes place in-house, all knowledge and property is protected within the company, which can give them an edge over time.

Risks

The risks of in-house production are:

• Lack of capacity: If the demand increases the capacity of in-house production might not be able to cover it.
• Increased inventory: If the demand decreases, the company might not sell enough to cover the production costs, and will result in increased inventory levels, which the company might not have made arrangements for.

Outsourcing

Benefits

The benefits of outsourcing are:

• Economies of scale: By aggregating multiple orders the cost is reduced.
• Risk Pooling: Suppliers reduce uncertainty through risk-pooling.
• Reduce capital investment: Capital investment is transferred to suppliers.
• Focus on core competency: The buyer can spend more time on improving and maintaining their core strength.
• Increased flexibility: Better reaction to changes in demand, and the buyer gains the ability to use technical knowledge, technology and innovation from the supplier.

Risks

The risks of outsourcing are:

• Loss of Competitive Knowledge: Outsourcing does not provide knowledge protection, and may open opportunities for competitors, as well as limit opportunities for companies to introduce new designs, insights, innovations and solutions.
• Conflicting Objectives: Demand and Product design issues may occur, because of changes in demand and slower reaction to design problems and changes.

When the procurement strategy has been defined and all outsourcing decisions been determined the next step is to define the buyer's need.

Defining the Buyer's Needs

A company will develop the statement of work (SOW) for each procurement. The SOW states the raw materials, products and/or services in detail. The suppliers will determine from the SOW if they are capable of meeting the buyer's needs with their people, skills, knowledge, capacity and other requirements needed. The SOW should include the following information, if they are applicable for the request:

• specifications
• desired quantity
• quality levels
• performance data
• period of performance
• work location
• other requirements

When the SOW has been written concisely for each individual procurement item, the procurement documents are prepared. These are prepared to request proposals from potential suppliers. The procurement documents may include request for information, invitation for bid, request for proposal, request for quotation, tender notice, invitation for negotiation, and invitation for seller's initial response, all depending on industry and location of the procurement. The documents should be accurately facilitated so the evaluation process of the responses is easy. The documents should be designed to ensure consistent and appropriate responses from potential suppliers.

Determining the Qualification of a Supplier

The third step is to examine the supplier's qualification and availability. The selection criteria is stated in the procurement documents, and often depends on many factors. It might only have one factor, cost, but in various businesses the requirements are more. Various factors to consider are:

• Understanding of need: The supplier's responsiveness to the procurement statement of work.
• Overall or life-cycle cost: Total cost of ownership (purchase cost plus operating cost).
• Technical capability: The technical skill and knowledge.
• Risk: The risk included in the statement of work and the risk assigned to the supplier.
• Management approach: Capability to develop, and manage processes and procedures to ensure a successful project.
• Technical approach: Technical methodologies, techniques, solutions, and services available.
• Warranty: Supplier's warranty for both the procurement and which time period.
• Financial capacity: Financial resources available.
• Production capacity and interest: Capacity for requirements available.
• Business size and type: Category of business.
• Past performance of sellers: Past experience from other suppliers.
• References: References from prior customers verifying their previous experience from the supplier.
• Intellectual property rights: For the work processes or services used.
• Proprietary right: For the work processes or services used.

Each business must identify their own selection criteria, depending on complexity of the product or service. Pharmaceutical companies selling on the US market for example, must select a supplier approved by the FDA (Food and Drug Administration) and the supplier must be audited to confirm they fulfill certain rules and regulations.

To verify a supplier's qualification buyers can take proactive steps. The buyer may ask previous customers for reference, and have them confirm a delivery performance and inform about any problems that arose. They may as well do financial status checks, and check if the supplier has access to more workforce or unused capacity of facilities in case of unexpected increase in demand. The buyer might have requirements of specific quality standards that need to be verified with the supplier, as well as request samples of supplier products and test them to see if they meet requirements.

If there are multiple suppliers that meet all requirements within the buyer's selection criteria the next step will provide further ways to analyze suppliers.

Choosing a Supplier

The qualified suppliers that fit the selection criteria might be multiple, but what would be the decision factor in those cases? The following tools and techniques can be used when potential suppliers have been identified:

• Bidder conferences: Conferences between the buyer and all potential suppliers to ensure that they have a clear understanding of the procurement requirements.
• Proposal evaluation techniques: A formal evaluation review process based on the buyer's procurement policies.
• Independent estimates: Make an estimate of costs, and if the costs differentiate by a large amount, ensure that all suppliers understood the statement of work well.
• Expert Judgment: Form a multi-discipline review from various departments within the company to evaluate.
• Advertising: Expand the list of potential suppliers by advertising.
• Analytical techniques: Used to identify if the supplier is fit to meet the requirements and attain the expected cost.
• Procurement negotiations: Used to reach a mutual agreement on all requirements and terms before the contract is signed.

When appropriate tools and techniques have been applied and potential suppliers determined to be in a competitive range, one will be selected. This decision is made by the procurement team with an approval from senior management.

Contract Management

The last step is to form a contract between the buyer and the supplier. Two types of legal contracts can be established, fixed-price contracts and cost-reimbursable contracts.

Fixed-price contracts contain a fixed total price for a specific product or service to be provided. This type of contract also often includes financial incentives regarding specific project objectives, that can be quantified and measured. Suppliers are legally obligated to fulfill fixed-price contracts, resulting in fees if requirements are not met. Fixed-price contracts split into:

• Firm Fixed Price Contracts: The most common contract, with a set price for goods or services and not subject to change. If a cost increase occurs the supplier is responsible and is bounded by contract to complete the task. In this type of contract the buyer is obligated to state specifically all products or serviced to be procured.
• Fixed Price Incentive Fee Contracts: This arrangement gives some flexibility that allows some deviation in performance from the supplier. Performance target is set before the production starts but the final contract price is decided after it has completed. In the beginning a price ceiling is set and any increase above that is the responsibility of the supplier.
• Fixed Price with Economic Price Adjustment Contracts: This arrangement is usually used for a long-term contract over a period of years, which has a fixed price, but is subject to changes such as inflation changes, or cost changes for raw materials. This type of contract protects both the buyer and supplier from out-of-control conditions.

Cost-reimbursable contracts involve cost reimbursements from the buyer to the seller for all actual costs that occur during the production, with a fee representing seller profit. It often includes financial incentives if the supplier does not meet preset targets for cost, schedule or technical performance. Cost-reimbursable contracts split into:

• Cost Plus Fixed Fee Contracts: The buyer pays for all costs occurring during the contract work, with an added fee representing the profit of the supplier, which is a percentage of the cost of completed work.
• Cost Plus Incentive Fee Contracts: The buyer pays for all costs occurring during the contract work, as with the Fixed Fee Contracts, but in this type of contracts gets a predetermined fee based on how well preset performance targets are met, which have been stated in the contract before the project starts. If final costs deviate from the initial estimated costs, both the buyer and the supplier share the costs based on a prenegotiated cost-sharing formula.
• Cost Plus Award Fee Contracts: This arrangement has predefined performance criteria, and the buyer pays for all costs occurring during the contract work. However, the additional fee is determined based on the satisfaction of the performance criteria. In this case the buyer can determine the satisfaction and decide the additional fee.

The third type of contracts is Time and Material Contracts which is an aspect involving both fixed-price and cost-reimbursable contracts. They are often used when the work desired cannot be quickly prescribed. They can be left open ended and relate to cost-reimbursable contracts by being subject to increased costs for the buyer. Detailed requirements cannot be stated by the buyer initially so the contracts can increase in value. However, many Time and Material contracts have value ceilings and time limits to prevent unlimited growth. This relates to Fixed Price Contracts with certain specified parameters.

Conclusion

In conclusion the tendering phase of the project procurement management includes multiple steps. First the company must justify the reasons for either producing in-house or outsource and make a procurement plan and strategy. The company must state their problem and needs in detail to determine the necessary deliverables from a supplier, and then determine the qualification of suppliers. Suppliers considered must have the skills, knowledge, workforce, and capacity to meet the buyer's demand. When all potential suppliers have been ruled, and proposals have been requested, one needs to be chosen. Tools and techniques for determination were presented.

The last part of the article introduces contract management which explains the step after the supplier has been chosen. When the supplier has been chosen a contract between the buyer and the supplier needs to be formed. Three types of contracts have been introduced, fixed-price contracts, cost-reimbursable contracts and time and material contracts which are a mix of the two previously mentioned.

This article aims to analyze the tendering phase of the procurement process within a company. Supplier selection and contract management have been discussed in detail and key points been presented.

Annotated bibliography

William R. Duncan. (2013). A Guide to The Project Management Body of Knowledge: The book provides a standard terminology and guidelines for project management. It gives a good understanding of various aspects of project, portfolio and program management. The guide provides guidelines of how to use and apply project management concepts and practices. The guide provides deeper insight into the topic of Project Procurement Management in Chapter 12 which was used as reference throughout the whole article. Further reading in this chapter gives the reader a even deeper understanding of project procurement management and contract management.

Simchi-Levi, D., Kaminsky, P., Simchi-Levi, E. (2003). Designing and Managing the Supply Chain: Concepts, Strategies, and Case Studies: The book covers important supply chain issues, and provides models, concepts, and solution methods to improve supply chain systems. It covers the design, control, operation and management within the supply chain and guides the reader through all steps through both theory and multiple case studies. The guide provided a deeper insight in Procurement and Outsourcing Strategies in Chapter 9 which was used as reference in this article, to introduce the benefits and risks of in-house production and outsourcing. Further reading in this book gives the reader a better understanding of the whole supply chain and provides solution to important supply chain issues.

Beil, D. (2009). Supplier Selection. Stephen M. Ross School of Business: The paper provides a detailed analysis of how to select a supplier. During a supplier selection companies identify, evaluate and make a contract with suppliers. When companies choose a supplier to compensate for a specific service, they expect significant benefits and high value deliverables. This paper describes steps of the process such as identifying suppliers, gathering information from suppliers, setting contract terms, evaluating and negotiating with suppliers. Further reading in this paper gives the reader a more detailed analysis of how to select a supplier.