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 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:
- The degree of responsibility the supplier assumes for the actual costs of performance.
- 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.
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Fixed Price
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Cost Reimbursable
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Form of Payment
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Firm lump sum
Firm unit prices
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Cost plus percentage of costs
Cost plus a fixed fee
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Form of Incentive
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Fixed price plus an incentive fee
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Cost plus incentive fee
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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.
Incentives
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
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Variables
Involved in Forming a Contract
