This article originally appeared in the January 2003 issue of The Rational Edge E-zine on-line magazine, copyright 2002-2003 IBM and Max Wideman.

The Rational Unified Process (RUP) is a rigorous software development process advocated by the Rational Software Corporation.

The downloadable PDF file of the paper on this site is the one prepared by the Rational Edge editorial staff with the special assistance of Ms Marlene Ellin.

Published here September, 2003.

PART III | Recap | Variables Involved in Forming a Contract
Selecting the Optimum Form and Type for Your Contract
Negotiating a Warranty | PART V

Selecting the Optimum Form and Type for Your Contract

Because contracting involves so many possible variables, it is important to select a document form -- and the type of document -- that can reflect both parties' choices regarding these variables. A contract document that does not properly reflect the intent between the parties, or one that is unnecessarily verbose or arcane, is a source of unnecessary risk to both sides.

Contract Form

Many industries and jurisdictions have well-established standard contract documents that suit various typical circumstances. As the language in such documents is usually well understood by those in the industry and has probably been interpreted by the courts, using these documents can help you lessen the likelihood of misunderstandings between acquirer and supplier.

A standard purchase form order will suffice for orders of standard off-the-shelf software or units of software licenses with little or no customization, providing that payment is based on a fixed price or quantity-based unit prices. A more comprehensive, more individualized document is required if any significant amount of customization work is involved; the manner ofpayment must also reflect the greater amount of work. Figure 11 illustrates this progression.

Figure 1: Software Development Involves a Non-Contracting Third Party: The User
Figure 11: Determining the Best Form for a Contract

Contract Type

Contract type refers to the commercial terms of the contract -- that is, the basis for payment. Given the nature of software products, two considerations govern the selection of contract document type:

  1. The degree of responsibility the supplier assumes for the actual costs of performance.
  2. The profit incentive the acquirer offers to the supplier for achieving or exceeding the specified goals, standards, or targets.

The range of payment options is illustrated in Figure 12.


Fixed Price

Cost Reimbursable

Form of Payment

Firm lump sum
Firm unit prices

Cost plus percentage of costs
Cost plus a fixed fee

Form of Incentive

Fixed price plus an incentive fee

Cost plus incentive fee

Figure 12: Range of Contract Payment Options

From the acquirer's perspective, a fixed price assigns maximum responsibility for a quality result to the supplier, together with an incentive for efficiency. Both of these conditions benefit the acquirer, but acquirers should select a fixed-price type of contract only if there is a complete understanding of the scope of work that can be conveyed effectively to potential suppliers. Acquirers should not price undefined or incompletely understood work this way. If the scope of work is open to interpretation, they should base the specific contract terms on an analysis of the risks involved.


The objective of incentives is to align the interests of the supplier with those of the acquirer. Incentives usually take the form of monetary bonuses for improving:

  • Negotiated costs
  • Delivery schedule
  • Technical performance
  • Reliability or other desirable outcomes

If you are offering incentives, you can also impose corresponding penalties for failing to meet specified targets. However, note that in practice it is difficult to make precise assessments of performance to calculate incentive payments, and final settlements typically end up being negotiated.

You can define cost performance incentives in terms of:

  • Target cost or price
  • Ceiling (maximum) or floor (minimum) price
  • Point at which acquirer assumes total responsibility for product operation
  • Sharing ratio: acquirer's share versus supplier's share

Variables Involved in Forming a Contract  Variables Involved in Forming a Contract

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