The outcome of successful negotiations is a contract, purchase order or another form of agreement. This section covers the management, preparation and issuance of such agreements’ documentation. Contract elements, types of obligation documents, purchase orders, binding and non-binding letter instruments, contract/agreement types, and more will be covered.

1. Elements of a Contract

The ISM Glossary 6th edition, defines a contract as a legally enforceable written or oral agreement between two or more competent parties that defines a job or service to be performed. While often used interchangeably with “agreement,” the legal definitions of the two terms are different. A contract is defined in UCC §1-201 (11) as “the total legal obligation which results from the parties’ agreement as affected by this Act and any other applicable rules of law.” A contract refers to the total legal obligation that is the result of an agreement. The parties may agree to and create a contract for anything, as long as it is legal, and meets the basic obligations of good faith, diligence and reasonableness. A contract has five essential elements: 1) offer and acceptance, 2) consideration, 3) competency and capacity of parties, 4) legality of purpose, and 5) mutuality of obligation.

Offer and acceptance

The ISM Glossary 6th edition, defines an offer as a proposal to make a contract. An offer is a binding expression of interest and willingness to create a contractual relationship, usually including certain terms. A contract must result from the mutual agreement of the parties to the contract. Mutual assent is often reflected in an offer made by one party (the offeror) and the unconditional acceptance of that offer by another party (the offeree). Preliminary discussions and correspondence about price, quality, quantity and/or other issues do not constitute a contract, nor do price quotations or advertisements. These are only preliminary steps to a contract. The issuance of a purchase order or submission of a price quotation, however, may constitute an offer to contract and be binding on the party making it when the other party accepts it.

1. Counteroffer — A counteroffer is an offer to enter into a transaction on terms different from those originally proposed (ISM Glossary, 6th edition). That is, a counteroffer is an offer made by an offeree to an offeror accepting some terms and changing others. It terminates the original offer, and proposes a new and different offer.

1. Acknowledgment — The ISM Glossary 6th edition defines an acknowledgement as a communication (written or electronic) used to inform the buyer that the supplier has accepted a purchase order. An acknowledgment creates a bilateral contract, as long as the terms of the acknowledgment are not substantively different from those of the purchase order.
2. Mistake in sending an offer — If a mistake is made in an offer, generally the terms of the offer with the mistake will stand unless the offeree was aware or should have been aware of the mistake.
3. Termination of offer — If a time period is specified, an offer will remain open until that time period has passed. If no time period is specified, the offer will expire after a “reasonable” time period. Offers can be revoked verbally, in writing, or by conduct consistent with the offer no longer being available.
4. Irrevocable offer — An offeree can purchase the right to have an offer stay open for a specific time with agreed upon terms. During this timeframe, the offeror cannot revoke the offer.

Competent parties

A competent party is recognized by the law as being able to enter into a valid contract.

Mutuality of obligations

A valid contract requires that both parties to the contract are bound to carry out their obligations. Also referred to as mutuality of contract, this is reflected in the offer by party and the acceptance by the other (ISM Glossary 6th edition).

Developing Contracts

Developing effective contracts is essential to ensuring that suppliers meet all requirements while managing the buying organization’s costs and risks. A contract is “a legally enforceable written or oral agreement between two or more competent parties that defines a job or service to be performed” (ISM Glossary 6th edition). A contract serves an important purpose for both the buyer and the supplier; it explicitly delineates the roles and responsibilities of both parties and helps the parties to reach an understanding and resolve potential disputes. Contracts should be fair and reasonable to both the buying organization and the supplier and set the tone for the working relationship.

When developing contracts, supply management professionals must understand the elements required to form a legally binding contract. There are several different types of contracts, so it is important to determine what type of contract creates the most value for the organization depending upon the sourcing situation. Supply management professionals must understand how to protect intellectual property as well as the laws that govern contracts both domestically and internationally. In addition, it is important to understand how Ts & Cs affect the organization and the supplier.

Understanding Contracts

To do business together, buying organizations and their suppliers must be willing to create a contract that legally binds them to fulfill their obligations. The legal definitions of a contract versus an agreement are different. In the U.S., a contract is defined in Uniform Commercial Code (UCC) Section 1-201 (11) as “the total legal obligation which results from the parties’ agreement as affected by this Act and any other applicable rules of law.” An agreement can build on both parties’ spoken language or visible actions and may facilitate a contract, while a contract legally obligates them to meet the requirements in good faith and with due diligence. In the United States, UCC Section 1-201(3) defines an agreement as “the bargain of the parties in fact as found in their language or by implication from other circumstances including course of dealing or usage of trade, or course of performance. Whether an agreement has legal consequences is determined by the provisions of the Act, if applicable; otherwise it is determined by the law of contracts” (ISM Glossary 6th edition). Because of the growth of interstate and international commerce, the law of contracts has been shaped by a process of developing uniform statutes that are designed to codify certain legal principles in a consistent manner from state to state within the U.S., and even across national boundaries.¹

Elements of a Contract

Initial discussions of price, quality, and delivery terms are all part of reaching a mutual understanding and agreement, but they are not considered a legally binding contract. However, a purchase order or price quotation submitted to the other party through a formal communication channel may, in fact, be legally binding depending upon the laws of the country governing the contract.

An offer is a binding expression of interest and willingness to create a contractual relationship usually including certain terms (ISM Glossary 6th edition). Either the buying organization or the supplier can make an offer. For example, a PO is an offer to buy. After an offer, the other party may make a counteroffer. A counteroffer is “an offer to enter into a transaction on terms different from those originally proposed” (ISM Glossary 6th edition). Once a counteroffer is made, it negates the original offer and delineates a modified offer. If the buyer issues a purchase order, which constitutes an offer, the supplier may inform the buyer that it has been accepted. This acknowledgment or formal acceptance creates a bilateral contract if the terms of the acknowledgment are not substantively different from the offer. If there is mistake in the terms of the offer, generally the offer will stand unless the offeree knew or should have known there was a mistake. Offers can be terminated if the specified time period has passed, a “reasonable” time has passed, or the offer is revoked by the offeree. In some cases, the offer may be irrevocable during a certain agreed-upon time period.

The element of consideration refers to the legal requirement for a contractual promise to be binding; something of value must be given up in exchange. The value exchanged can be money, goods, services, exclusive dealing, promise, or giving up of rights. The value exchanged does not need to be equal or fair as long as value is exchanged. Gifts, providing value for something that has already been completed, or doing something that you are already legally bound to do are not consideration. Both parties must be of legal age and have capacity to enter into the contract. Capacity encompasses both the mental capacity when entering into the contract and legal authority to enter into the contract on behalf of an organization. The purpose of the contract must be legal. Both parties to the contract must be bound to carry out their obligations.

A contract may be rendered orally or in writing, both are legally binding depending upon the situation. In the U.S., the UCC Statute of Frauds requires certain contracts to be in writing to be enforceable for cautionary and evidentiary reasons. Contracts covered by the requirement include sale of goods for US$5,000 or more, lease of goods for US$1,000 or more, contracts for services that cannot be performed within one year, and real estate transactions (ISM Glossary 6th edition).

In some circumstances, oral contracts are acceptable for goods worth US$500 or more.

A prudent supply management professional may use oral contracts when the convenience of an oral contract is high and the risk of contract violation is low. For instance, if a buyer is pressed for time (for example, there is not enough time to issue a written contract) and the purchase involves a low-cost item, then the buyer may issue an oral contract. Also, when the buyer and supplier have maintained a long and fruitful relationship, the supplier may begin work based on an oral contract. In either case, the oral contract should be followed by a written one, such as a purchase order.

2. Types of Contract Documents

In addition, the doctrine of promissory estoppel is the legal theory under which a definitive promise made by one party and justifiably relied on by another will be enforced, even though the requirements of contracting may not be met (ISM Glossary 6th edition).

1. Electronic — Digital technology allows the contracting process workflow and communication to be done electronically.
   1. Digital signatures — With the passage of the E-Sign Act in the United States, electronic signatures can serve in place of conventional hand signature of documents for national and global transactions. An electronic signature clause should be included in contract Ts & Cs.

Types of Obligation Documents

There are several types of obligation documents that are used in supply management. These include purchase orders (POs), trading partner agreements, letters of intent, and letters of authorization.

A PO is perhaps the most common type of obligation document and is prepared “to describe the terms and conditions of a purchase. In the contracting process, the purchase order may function as an offer, an acceptance, and a confirmation of an oral agreement, or a trigger for a periodic performance (release) under an established contract” (ISM Glossary 6th edition). For instance, if a PO is issued in response to a supplier’s quotation, then the PO may serve as an acceptance. However, if a PO is issued as an offer, it may not constitute a contract; it becomes a contract only after acceptance by the supplier. If an acknowledgement or other acceptance form is not requested, the PO is considered a unilateral contract when it is based on an offer by one party, with acceptance formed by the actions of another.

Digital signatures can be used for contracts and an electronic signature clause should be included in the contract Ts & Cs.

A letter of intent is “a precontractual document used to express expectation of contract formation in the future. When properly drafted, a letter of intent should create no binding obligation on either party” (ISM Glossary 6th edition). When the letter of intent is issued, it is expected to be superseded by a legally binding contract. If a letter of intent is to be nonbinding, it must include an explicit and clear statement to that effect. The purpose of a letter of intent is to gain time by committing to a supplier prior to issuing a more complete PO or contract. Often, letters of intent are issued when the buyer needs to reserve capacity at the supplier’s facility, the total volume of business to the supplier is yet unclear, the buyer needs the supplier to maintain an inventory of certain parts or raw materials (for example, what is needed for the provision of a service), or the supplier needs some evidence to secure bonding.

A letter of authorization outlines an individual’s ability and limit for entering into a legally binding contract. The letter includes rank, spending limits, and actions allowed.

Purchase Orders

The ISM Glossary 6th edition defines a purchase order (PO) as a legally binding document prepared by a purchaser to describe the terms and conditions of a purchase.

Purchase order confirmations and acknowledgments

When to use — Formal confirmations and acknowledgments are used when it is important to the supply management professional to document that a contract exists. The supplier’s return of an acknowledgment completes the contracting requirements of an offer and acceptance.

Seller’s exceptions to purchaser’s items — The supplier should notify the supply management professional of any exceptions to the Ts & Cs of the offer to purchase.

Purchaser’s exceptions to seller’s items — The supply management professional should notify the supplier of any Ts & Cs of the offer to sell that may not be agreeable to the buying organization.

Purchasing Card (P-Card)

Purchasing cards, also called procurement cards, are company credit cards that allow the end user to place and pay for orders directly with suppliers. P-cards reduce the number of routine transactions for supply management and accounts payable (ISM Glossary 6th edition).

3. Binding and Nonbinding Letter Instruments

1. Letters of intent — The ISM Glossary 6th edition defines a letter of intent (LOI) as a pre-contractual document used to express expectation of contract formation in the future. When properly drafted, the LOI should create no binding obligation on either party.

Contract/Agreement Types

The contract form used in a specific case will depend on many factors, such as the intensity of competition, availability and accuracy of pricing data, relative risks as perceived by the supply management professional and supplier, and the relative strength of the supplier’s position or the supply management professional’s position.

1. Letter contracts — The ISM Glossary 6th edition defines a letter contract as a preliminary written contractual instrument that authorizes the contractor to immediately begin contract performance. The letter contract typically is followed by a definitive contract document. Good practice dictates stating clear limits to the buying organization’s liability (in the event the whole contract cannot be satisfactorily concluded) and asserting the buying organization’s Ts & Cs of purchase.
2. Blanket agreement — A blanket agreement, also called a blanket order, is a commitment to purchases services or goods over an agreed upon time frame, according to the ISM Glossary 6th edition. Blanket agreements can reduce administrative costs by reducing the number of orders processed, and can provide the supplier with a greater understanding of the buyer’s requirements, increasing the efficiency of operations.

1. Professional service agreements — Contracts for legal, accounting, auditing or other types of professional services.
   1. Performance-based agreements — Contracts for services in which outcomes or timelines are specified in the terms (ISM Glossary 6th edition).
2. Licensing agreements

General licensing agreements may cover permission to use logos, brand names, registered terminology, and similar items.

1. Technology — Technology agreements provide for the use of patented processes by others for an agreed-upon fee.
2. Master purchase or supply agreements (IT, hardware, desktop, supplies, materials) — Master purchase agreements are often used to purchase computers, equipment, and MRO supplies. When needed, orders are placed as required against the contract.
3. Specialty contracts — There are several types of specialty contracts, including construction contracts, treaties, trade agreements, utility or power agreements with other countries for infrastructure improvements, and contracts in government procurement. Construction contracts typically include project-based performance guidelines. Clauses respecting safety, environmental impact, social responsibility, milestone payments, and penalties are normally included. Construction contracts are normally written based on established standards and zoning requirements, and appropriate laws within the geographic region. Contracts in the government/public sector are usually subject to certain requirements, which are less stringent or nonexistent for private organizations. For example, contracts in the public sector usually have to be advertised widely, and structured in such a way that they do not disadvantage smaller suppliers (for example, lots need to be small enough to allow reasonable competition).

Types of Contracts

To make sure the buying organization achieves its goals, it is essential to select the right type of contract depending upon the sourcing situation. Contracts determine how obligations, costs, and risks will be shared between the buying organization and supplier, and how supplier performance will be evaluated. Contracts are categorized by their characteristics and purposes, mostly around some type of pricing plan. For instance, fixed-price contracts set the price, while cost-reimbursable contracts determine price based on the cost of work performed. There are several different categories of contracts including fixed-price, cost-reimbursable, indefinite-delivery, time–and-material contract, letter, blanket agreement, dealer’s agreements, service agreements, and other types of contracts.

Fixed-Price Contracts

This type of contract “refers to a family of pricing arrangements or contract types whose common characteristic is a ceiling beyond which the buyer bears no responsibility for payment” (ISM Glossary 6th edition). Longer time frames and complexity increase supplier risk with fixed-price contracts. Figure offers an overview of fixed-price contracts, including a description of what each type means, how it can best be applied, and the managerial implications for both the supplier and the buying organization.

In firm fixed-price contracts, after the contract is signed, the price will not change, regardless of what happens to economic conditions, industry competition, and supply market. Because the supplier may incur higher costs than what was used to fulfill the contract (due to increasing market prices for procured raw materials and parts), the supplier may try to work in a reasonable profit margin to account for any potential increases. Therefore, you need to understand the supply market conditions that the supplier faces before agreeing to a firm fixed-price contract. With firm fixed-price contracts, the supplier has incentives to reduce its costs to increase its profit margin.

The actual cost of the raw materials, parts, or services can be highly uncertain; depending on how the prices of raw materials and parts behave in the market, there will always be a “winner” and a “loser” under the basic firm fixed-price contract.

Many unknown factors can exist at the time of contracting, beyond just the raw materials cost or service process issues as in the case of the fixed-price-with-escalation contract. Proposed technology may not be proved, labor cost might change significantly, or the amount of raw materials and parts to be used could not be determined with confidence. Both parties need to discuss and agree on whether the new price would apply only for work still to be performed, or would apply for all or a portion of the work performed prior to the redetermination. The fixed-price-with-downward-price-protection contract offers maximum protection for the buying organization. If the price moves up, the contract is not negotiated and the buyer receives the gain. However, if the price moves down, the buyer renegotiates the price.

In the case of redetermination of a contract, the supply management professional and the supplier agree on the target price based on their best estimates; however, in the case of an incentives contract, the contract includes a stipulation for potential cost reduction performed by the supplier. When the cost reduction is achieved by the supplier over time, the savings are shared by both the buyer and supplier. The percentage for sharing is typically 50/50 but can be negotiated. The fixed-price-with-incentives contract occurs most frequently when the unit or service cost is high at the time of contracting, and the contract spreads over a long period of time. This type of contract is also more common for projects based on work such as construction or for custom-made equipment. In some situations, such as development of a new product or some consulting projects, it is not possible to accurately define the work or results at the beginning of the project. A fixed-price-per-unit-level-of-effort contract is then used, in which a rate per hour of effort and maximum number of hours is agreed upon. When the maximum is reached, the contract is re-evaluated.

During the life of a contract, changes may happen so that one or both parties may not be able to meet their contractual obligations. If this happens, damages can occur; therefore, both parties may choose to include clauses for such potential damages by establishing a fixed-price-with-remedies contract. A fixed-price-with-remedies contract may make the remedies against these damages explicit or may include any other potential damages beyond what the law typically may allow.

Cost-Reimbursable Contracts

Cost-reimbursable contracts provide for payment of allowable, allocable, and reasonable costs associated with the performance of a contract up to a predetermined level (ISM Glossary 6th edition). These contracts guarantee the supplier a price sufficient to cover allowable costs plus whatever additional amount is negotiated as a fee. The buying organization bears the financial risk for cost-reimbursable contracts. See Figure for an overview of these types of contracts.

TYPE	DESCRIPTION/ APPLICATION	IMPLICATIONS FOR SUPPLIER	IMPLICATIONS FOR PURCHASER
Cost Plus Fixed Fee	This contract puts a ceiling on how much the supplier can spend, plus a negotiated fee.	The supplier is ensured of covering its costs plus a fee as long as it stays within the predetermined ceiling amount. However, there is little incentive to reduce costs.	The buyer is protected from the potential risk of the supplier incurring too much cost.
Cost Plus Percentage of Cost	The buyer agrees to reimburse the supplier for the cost incurred plus a percentage markup for that cost.	In essence, the supplier is rewarded for spending money.	The buyer has little control over cost incurred by the supplier.
Cost Plus Incentive Fee	The buyer agrees to pay the supplier for the target cost plus an additional fee as an incentive to contain costs.	If the cost comes out above the target cost, the supplier loses that amount from the incentive fee.	If the cost comes out below the target cost, the buyer and supplier share the savings at the agreed-upon proportions (generally, 50/50).
Cost Without Fee	Supplier receives payment for the costs it incurs but nothing else. This is often used in not-for-profit organizations such as universities.	Supplier is allowed to cover the cost.	The buyer receives services from the supplier without paying a profit margin.
Cost-Sharing	Both the buyer and supplier agree to share costs.	The supplier shares the costs and benefits of work being conducted.	The buyer shares the costs and benefits of work being conducted.

In the case of the cost-plus-fixed-fee contract, the supplier is paid for the cost expended or the ceiling, whichever is lower, plus a fixed fee that is agreed on at the time of contracting. The cost-plus-percentage form of contract can encourage a supplier to incur more costs. This contract offers the supplier the cost incurred as well as a percentage of that cost. Most public sector organizations do not permit this form of contract. It is commonly used by distributors of spare parts, operating supplies, and similar items.

The cost-plus-incentive-fee form of contract is similar to the fixed-price-with-incentives contract in that both sides agree on a target. However, the base price depends on the cost incurred and not on a fixed price agreed upon at the time of contracting. The cost-with-out-fee contract often occurs between a funding agency and not-for-profit organizations, such as research groups or universities. It allows the not-for-profit organization to cover its costs such as overhead, labor, and expenses incurred, but it allows no profit. With the cost-sharing contract, both the supplier and buying organization are responsible for what happens during the life of the contract. For this form of contract to work, it is imperative that both parties agree on a clearly understood set of operating guidelines, how the costs are going to be shared, and in what proportion the costs will be shared.

Indefinite-Delivery Contracts

This form of contract is used when the exact times and quantities of future deliveries are not known at the time of contracting but minimum and maximum quantities are usually specified (ISM Glossary 6th edition). It is used to cope with uncertainties involved in scheduling, timing of a service activity, quantity of materials, or the frequency of the service required. Figure offers a list of major types of indefinite-delivery contracts, and gives a brief description of each.

Service-Level Agreements

Service-level agreements are used when purchasing services and should address all aspects that were covered in the statement of work (SOW). For example, professional services for legal services would use a professional service agreement, or equipment maintenance would use a maintenance agreement. Master service agreements (MSA) are contracts that are negotiated to cover future work. These agreements typically contain all contracting Ts & Cs, the metrics and means of measurement, the consequences in the event of failure to perform, and any longer-term aspects of the agreement so they do not have to be renegotiated each time a new contract is established with a service supplier. Performance-based agreements specify expected results and the timeframe for performance (ISM Glossary 6th edition).

Licensing Agreements

A license agreement is entered into “between two organizations allowing one to sell the other’s products or services or to grant the rights to intangible property to the licensee for a specified period in return for a one-time payment or ongoing royalty” (ISM Glossary 6th edition). General licensing agreements can address use of brand names, terminology, or logos.

Master Purchase Agreements

When an organization has recurring purchases, a master purchase agreement can be used to reduce administrative costs while ensuring that standardized pricing and Ts & Cs are used. Master purchase agreements refer to “contractual arrangements with a supplier that define price and terms of business but do not contain specifics of release or delivery. Separate purchase orders are released later as goods or services are needed; these reference the master purchase agreement, whose price and terms are incorporated by reference” (ISM Glossary 6th edition). Master purchase agreements can allow an organization to leverage its spend across locations and are also used by governmental agencies and not-for-profit consortia. For example, Inter-University Council of Ohio has master purchasing agreements in place for purchases such as audiovisual and video equipment, computer hardware, dormitory mattresses, office supplies, moving services, and group dental benefits.³

Other Types of Contracts

A time-and-materials contract involves agreeing upon fixed hourly rates that include (1) wages, overhead, general and administrative expenses, and profit; and (2) materials, generally at cost, including, if appropriate, material handling costs (ISM Glossary 6th edition). Most automobile repairs, for example, are conducted under time-and-material contracts.

A blanket agreement is a commitment to make purchases over a time frame, usually one year or more.

A letter contract is “a preliminary written contractual instrument that authorizes the contractor to begin immediately performing the manufacturing or service requested. The letter contract typically is followed by a definitive contract document” (ISM Glossary 6th edition).

A dealer’s agreement is a contract, expressed or implied, and occurs between a supplier and a dealer, or is issued by a supplier. With this agreement, the dealer is granted the right to purchase, sell, distribute, or service the supplier’s merchandise.

A specialty contract is written, signed, sealed, and delivered, as is the case with deeds and bonds.⁴ The formality of a specialty contract sets it apart from simple contracts. Types of specialty contracts include construction, capital equipment, government contracts, treaties, and trade agreements. These contracts are often highly complex, unique, cover a long time period, and can be challenging to negotiate.⁵

Key Considerations in Preparing Contracts

Supply management professionals must consider many factors when developing contracts. Some of the key factors include intellectual property, domestic and international laws, and Ts and Cs.

Intellectual Property

Intellectual property (IP) refers to “various types of intangible personal property that have an inherent commercial value and are protected by the government in different ways. They include copyrights, patents and trademarks, or service marks” (ISM Glossary 6th edition). Nondisclosure agreements are typically used to protect confidential information. When preparing contracts, you must be aware of the IP rights of the buying organization, the supplier, and others that might potentially be involved in the transaction. It is critical to understand the embedded nature of IP. An organization’s IP might become embedded in another organization’s IP. High-tech organizations work hard to get their IP embedded in other technologies so they can collect licensing fees.

A copyright represents protection by U.S. law, which grants “the authors and creators of original literary, dramatic, musical, artistic, and other intellectual property, published or unpublished, the exclusive right to publish, reproduce, display, sell, perform, transmit, or prepare derivative works from the original work” (ISM Glossary 6th edition). As is the case with any IP procurement, the licensee must try to obtain rights to the work produced for its organization that are as broad as possible and include indemnification provisions to protect the organization in the event the material being acquired infringes on some other party’s copyright. Digitization of processes and equipment must be considered. Software applications are covered by copyrights so it is important to understand the implications and restrictions created by end-user-license agreements (EULAs) when purchasing equipment.⁶

A patent signifies the right to exclude others. Sanctioned by a government, it creates a monopoly and gives “the patent holder the sole right to make, use, and/or sell the patented articles and to prevent others from doing so without the holder’s permission (license) for a set amount of time” (ISM Glossary 6th edition). It is important to agree upon patent rights when suppliers are involved in research and development efforts. When technologies come together to create a cumulative system of technologies, the effort to exclude others from using IP can be difficult. For example, Apple and its supplier Samsung have sued each other over patent infringement. A patent indemnity clause should be included in the Ts & Cs to protect the buying organization against the consequences of infringement lawsuits.

A trademark is an “identifying label, symbol, or word(s) for exclusive use with a particular product (trademark) or service (service mark)” (ISM Glossary 6th edition). The licensee can obtain the rights to use the licensor’s trademark in the promotion of the licensee’s own organization. Trademarks must be registered with a country’s trademark office and trademark laws apply to only one country or jurisdiction. One key difference between trademarks and other IPs, such as patents and copyrights, is that trademark rights can last indefinitely as long as the holder of this IP continues to use it to identify its goods or services and renews its registration. In many cases, companies license trademarks to associate their products with quality reputations.

A royalty is a payment made in return for some privilege or right, typically the use of intellectual property such as patented or copyrighted materials. The payment is made by agreement with the property owner (ISM Glossary 6th edition) and is usually a fixed amount per unit sold or a percentage of sales. For example, publishing companies pay royalties to authors for publishing their manuscripts.

4. Considerations in Preparing Obligation Documents Such as Contracts and Purchase Orders

There are several issues that need to be addressed with preparing contracts and purchase orders.

1. Intellectual property — Intellectual property (IP) include copyrights, patents and trademarks/service marks. When preparing contract documents, your organization’s intellectual property rights, as well as those of their suppliers and other parties, must be addressed.

Confidentiality —Confidentiality or nondisclosure agreements that are part of the supplier relationship must be respected by both parties, and such agreements are typically mutual to both.

• Consideration of domestic and international laws — When entering into contracts, international as well as national laws must be considered.
  • Convention for the International Sale of Goods (CISG) — The United Nations Convention on Contracts for the International Sale of Goods (CISG) is a set of rules that has been adopted by key trading nations around the world, operating like a treaty. The CISG automatically applies when both contracting parties are in countries that have accepted the CISG, unless the parties specifically opt out of coverage.
  • Data privacy — Many countries are developing laws with respect to the use of data, including copying, storage, analysis, transfer, and disclosure. Contract clauses should ensure that suppliers comply with all regulations and laws governing the collection of personally identifiable information and Maintenance of data privacy.

Business continuity — Contract clauses should address responsibilities and actions that should be taken if a disaster or other event threatens to disrupt the performance of a contract. Contracts should require the supplier to develop a business continuity plan, which includes identifying risks, and developing specific response and mitigation plans if a disruption occurs.

1. Disaster recovery — Clauses on disaster recovery should address each party’s responsibilities, actions and the expected recovery time frame if a disruption occurs.
   1. Assurance of supply — Contracts should also define supply contingency plans for supply assurance in the event of a disaster.
2. Ethics and social responsibility issues — Contract clauses relevant to such topics as child labor, worker safety, nondiscrimination, ethical business practices, and environmentally responsible practices should be included in contracts.
   1. Consequential — According to the ISM Glossary 6th edition, consequential damages are not a direct result of a breach but happen as result of the breach, for example lost sales or personal injury. This clause will exclude these types of damages.
   1. Punitive — Punitive damages punish the supplier for wrong-doing. These are typically not awarded unless the act was deliberate and egregious (ISM Glossary 6th edition).
3. Prime contractor flowdowns — In U.S. federal government contracts, Ts & Cs that are required in the Federal Acquisition Regulation (FAR) are commonly added to subcontractor contracts. These can include regulations regarding child labor, use of small businesses, equal opportunity, and restrictions on certain international purchases to subcontractor agreements.

Duties, breach, notice, cure and remedies — After a contract is signed, both parties have the duty to fulfill the obligations agreed upon. A breach of contract occurs when either of the parties fails to perform their contractual obligations (ISM Glossary 6th edition). When this happens, the party that has caused the breach needs to be notified. Notice clauses should explain how notices are to be communicated. For example, when a defective part is sent, the notice is sent to the supplier by email.

Typically, contracts will have a cure for breach clause, which is the time frame in which the breaching party can correct the error and return to the original state of fulfilling the contract as originally agreed. The purpose of a remedy is to correct or provide relief to the party that has experienced damages as a result of the other party’s failure to perform their contractual obligations. An exclusive remedies clause limits the range of remedies that are available for a specific type of breach of contract.

• Asset management — Clauses should address how tangible assets such as equipment, buildings, and property, or intangible assets such as digital content and software will be managed during the contract.
• Representations — Representations are statements of fact but are not warranties.
• Jurisdiction and venue — A contract should include a clause that defines in the event of a dispute the location where legal proceedings will occur and the court that will have the power to hear and exercise control over the dispute (ISM Glossary 6th edition).
• Effective date — The effective date contract clause specifies the date when the contract takes effect.
• Third-party beneficiaries — The rights of third parties that may receive benefits from the contract, but do not directly enter into the contract as the offeree or the offeror (ISM Glossary 6th edition) should be explicitly defined.
• Conditional and promises of performance — A condition is a requirement that must be met for the obligations (promise of performance) to occur under the contract. For example, your company may pay for you to take the CPSM exam (the promise of performance), if you successfully pass the exam (the condition). The condition may occur before, simultaneously with, or after the performance of the obligation.

Key Considerations in Preparing Contracts

Supply management professionals must consider many factors when developing contracts. Some of the key factors include intellectual property, domestic and international laws, and Ts and Cs.

Intellectual Property

Intellectual property (IP) refers to “various types of intangible personal property that have an inherent commercial value and are protected by the government in different ways. They include copyrights, patents and trademarks, or service marks” (ISM Glossary 6th edition). Nondisclosure agreements are typically used to protect confidential information. When preparing contracts, you must be aware of the IP rights of the buying organization, the supplier, and others that might potentially be involved in the transaction. It is critical to understand the embedded nature of IP. An organization’s IP might become embedded in another organization’s IP. High-tech organizations work hard to get their IP embedded in other technologies so they can collect licensing fees.

A copyright represents protection by U.S. law, which grants “the authors and creators of original literary, dramatic, musical, artistic, and other intellectual property, published or unpublished, the exclusive right to publish, reproduce, display, sell, perform, transmit, or prepare derivative works from the original work” (ISM Glossary 6th edition). Digitization of processes and equipment must be considered. Software applications are covered by copyrights so it is important to understand the implications and restrictions created by end-user-license agreements (EULAs) when purchasing equipment.⁶

A patent signifies the right to exclude others. Sanctioned by a government, it creates a monopoly and gives “the patent holder the sole right to make, use, and/or sell the patented articles and to prevent others from doing so without the holder’s permission (license) for a set amount of time” (ISM Glossary 6th edition). It is important to agree upon patent rights when suppliers are involved in research and development efforts. When technologies come together to create a cumulative system of technologies, the effort to exclude others from using IP can be difficult. For example, Apple and its supplier Samsung have sued each other over patent infringement.⁷ There is also the potential liability for infringement when using a product that may be patented by someone else. A patent indemnity clause should be included in the Ts & Cs to protect the buying organization against the consequences of infringement lawsuits.

A trademark is an “identifying label, symbol, or word(s) for exclusive use with a particular product (trademark) or service (service mark)” (ISM Glossary 6th edition). The licensee can obtain the rights to use the licensor’s trademark in the promotion of the licensee’s own organization. Trademarks must be registered with a country’s trademark office and trademark laws apply to only one country or jurisdiction. One key difference between trademarks and other IPs, such as patents and copyrights, is that trademark rights can last indefinitely as long as the holder of this IP continues to use it to identify its goods or services and renews its registration. In many cases, companies license trademarks to associate their products with quality reputations.

A royalty is a payment made in return for some privilege or right, typically the use of intellectual property such as patented or copyrighted materials. The payment is made by agreement with the property owner (ISM Glossary 6th edition) and is usually a fixed amount per unit sold or a percentage of sales. For example, publishing companies pay royalties to authors for publishing their manuscripts.

Domestic and International Laws

Supply management professionals must be aware of international laws as well as the laws in the specific countries where their organizations have operations or where their suppliers are located. Legal issues are discussed in more detail in Section 8. With respect to contracts, the United Nations Convention on Contracts for the International Sale of Goods (CISG) is a treaty that governs international sales transactions.⁸ It is designed to create consistency in rules that govern international sales transactions and affects all organizations from countries that have ratified it and included it in their own legislation. However, the parties make an explicit agreement regarding the CISG and can opt out of the law’s coverage.

Restraint of trade is defined as “the effect of an act, contract, combination, or conspiracy that eliminates or stifles competition, effects a monopoly, artificially maintains prices, or otherwise hampers or obstructs the course of business as it would be carried out if left to the flow of natural and economic forces” (ISM Glossary 6th edition). Most countries have antitrust laws to protect the free enterprise system.

Terms and Conditions (Ts & Cs)

Ts & Cs is “a generic phrase referring to various requirements imposed on contracting parties by the language of their contract” (ISM Glossary 6th edition). It is essential to understand how Ts & Cs affect the buying organization’s costs and risks. The buying organization’s Ts & Cs should be included in all solicitations. Any changes made by the supplier should be carefully evaluated to determine their impact and negotiated if needed. In U.S. federal government contracts, Ts & Cs that are required in the Federal Acquisition Regulation (FAR) are commonly added to subcontractor contracts as prime contractor flow-downs.

A contract consists of both standard and custom Ts & Cs. Standard Ts & Cs are what the buying organization wants to apply to every contract.

Appendix: Issues Addressed by Ts & Cs

There are many issues that can affect the contract performance, costs, and risks that are normally included in standard or custom Ts & Cs.

Payment Terms

Payment terms involve a trade-off between the time the buying organization keeps the money before paying and the discount the supplier offers as an incentive for early payment. Payment terms have cash flow implications for both the buying organization and the supplier.

Insurance

In some situations, the supplier should carry a certain amount of insurance. Most supply management organizations specify in the contract the type and amount of insurance required. The clause might include statements about property damage, public liability, builder’s risk, errors and omissions, workers’ compensation, and related issues.

Termination and Exit Clauses

Termination means the “action of one party pursuant to specific contract language to end a contract for some reason other than breach by the other party” (ISM Glossary 6th edition). Upon termination, all obligations are discharged, except breach of rights and obligations based on prior performance. Typically, a termination for convenience clause is included that allows termination even though the supplier is complying with the terms of the contract. Cancellation differs from termination in that it implies cause and does not excuse the causing party from damages resulting from its failure to perform. “The right to cancel may be provided by law or in specific contract language” (ISM Glossary 6th edition).

Confidentiality Policies

Most information regarding customers, suppliers, and competitors is confidential. Many times there is a formal confidentiality or nondisclosure agreement that is a “freestanding agreement or contract provision restricting the disclosure of certain information, generally proprietary information, given by one party to the other in the course of contract performance and imposing liability for unauthorized disclosure” (ISM Glossary 6th edition).

Business Continuity

Contract clauses should address responsibilities and actions that should be taken if a disaster or other event threatens to disrupt the performance of a contract. Contracts should require the supplier to develop a business continuity plan that includes identifying risks and developing specific response and mitigation plans if a disruption occurs.

Source Code Escrow Accounts

When acquiring software or the rights to use software, an escrow account might become necessary. An independent third party serves as an escrow agent, physically stores the source code, and has title to it. The escrow agent also has authority to release it under specified conditions.

Claims

A claim refers to “the right asserted by a plaintiff to payment or for an equitable remedy, such as the specific performance of a contract” (ISM Glossary 6th edition).

Limitations of Liability

Suppliers, in general, attempt to include contract language that will limit their liability for damages and loss due to warranty claims or other breaches of contract. Limitation of liability is a “contract provision that restricts either the remedies available or the amount of damages recoverable in the event of a breach of contract. Such provisions are typically initiated by sellers, and may cap overall liability or certain categories of liability under the contract, or may exclude liability for certain types of damages, such as consequential damages” (ISM Glossary 6th edition). One of the most common limitations addresses warranty claims that the supplier be permitted to repair or replace defective goods. In this case, the supply management organization is not permitted to cancel the contract and seek damages for loss.

Waiver of Consequential Damages

To promote goodwill and to limit the potential escalation of damage disputes, contracting parties from both sides may agree to a waiver of consequential damages. Consequential damages refer to “damage, loss or injury that arises not directly from a party’s act (for example, breach of contract) but from some consequence or result of that act (for example, lost profit, lost revenue, personal inquiry, or property damage) (ISM Glossary 6th edition).

Collusive Offers

Collusion is a secret agreement to operate in a fraudulent or deceitful manner. In collusive offers, suppliers act together “to ‘fix’ their bids in a collectively advantageous manner and thus eliminate genuine competition in bidding” (ISM Glossary 6th edition).

Estoppel

Estoppel is “a legal principle that prevents a person from asserting a position that is inconsistent with his or her prior conduct if injustice would thereby result to a person who has changed position in justifiable reliance on that conduct” (ISM Glossary 6th edition). One example of this principle might occur in agency law when a purported agent is actually an impostor.

Ethics and Social Responsibility Issues

Contracts addressing issues such as child labor, worker safety, nondiscrimination, ethical business practices, and environmentally responsible practices should be included in contracts.

Domain/Jurisdiction

Domain or jurisdiction refers to an area that has the legal authority to hear and render a decision in a particular situation. Most contracts specify the jurisdiction.

Damages

The ISM Glossary 6th edition defines damages as “compensation for loss or injury suffered by one party as a result of another party’s actions.” Damages can be liquidated, direct, indirect, consequential, or punitive. To avoid the problems of calculating and proving damages in a lawsuit, contracting parties often will state a predetermined amount of damages, known as liquidated damages, in their contract. Direct damages are determined as the difference between the value of the performance received and the value that had been agreed upon in the contract. Indirect damages, also referred to as incidental damages, are expenses reasonably incurred in the inspection, receipt, transportation, and care of goods rightfully rejected by the purchaser (ISM Glossary 6th edition). According to the ISM Glossary 6th edition, consequential damages are not a direct result of a breach but happen as a result of the breach, for example lost sales or personal injury. Punitive damages punish the other party and generally are not allowed in contract law cases.

Warranties

A warranty is “a legally enforceable promise or representation as to quality or performance of goods or services made by the seller” (ISM Glossary 6th edition). Warranties may be express, which is assurance by the supplier, either orally or in writing, about the product’s or service’s quality, performance, or other characteristics.

Disclaimer of Warranty

It is important to use well-designed Ts & Cs to cancel out supplier disclaimers.

Duties, Breach, Notice, Cure, and Remedies

A breach of contract occurs when either of the parties fails to perform its contractual obligations (ISM Glossary 6th edition). When this happens, the party that has caused the breach needs to be notified. Notice clauses explain how notices are to be communicated. Remedies “relieve or correct a legal wrong. In contract terms, available remedies are money damages or an order of the court for specific performance” (ISM Glossary 6th edition). Generally, there is a timeframe that the breaching party is given to correct the breach and return to the original agreement called a cure (ISM Glossary 6th edition). Cover is a remedy available to a buyer. After displaying due diligence, the buyer is entitled to obtain goods in the open market and recover damages from the supplier (ISM Glossary 6th edition).

Asset Management

Contracts typically include clauses that address how tangible assets such as equipment, buildings, and property, or intangible assets, such as digital content and software, will be managed.

Third-Party Beneficiaries

In some cases, third parties who do not directly enter into the contract as the offeree or the offeror may receive benefits (ISM Glossary, 6th edition). Their rights should be explicitly defined.

5. Requirements Documents

When completing a contract, make sure all of documents used to communicate the purchase requirements are correct and complete. These documents may include:

1. Statement of work — The statement of work is used to communicate the requirements for services
2. Scope of work — A scope of work is part of the statement of work and describes the specific tasks required.
3. Specifications — Detailed product specifications should be included for purchases of goods. An explanation of the different types of specifications that can be used to communicate requirements.
4. Service level agreement (SLA) — A service level agreement is a contract that defines the specific performance required from the service provider, and how the service provider’s performance will be measured.
5. Items/price list — The item number, name, description, and price list should be checked for accuracy and included.

Communicating Needs

The second step of the sourcing cycle is to develop the detailed specifications that will be communicated to potential suppliers during the sourcing cycle. A specification “is a description of the technical requirements for a material, product, or service” (ISM Glossary 6th edition). Specifications must clearly communicate what the product or service must do or look like. Five types of communication methods are used most often: 1) performance specifications, 2) design specifications, 3) statements of work, 4) external specifications, and 5) supplier samples. Descriptions of these methods are shown in Figure.

TYPES	DESCRIPTIONS
Performance Specifications	Performance specifications define the characteristics of an acceptable product or service but not its details or how it should be made.
Design Specifications	Design specifications provide the details of how the product should be made or how the service needs to be carried out.
Statements of Work (SOW)	An SOW is a document used in services procurement to define exactly the nature of the work and the conditions under which it will be performed, such as the type, level, and quality of service, as well as the time schedule required.
External Specifications	External specifications are specifications set by the industry or government.
Supplier Samples	A physical sample can be used to communicate specifications. When the sample meets the buying organization’s requirements, the sample then is typically referenced as “specifications.”

Performance and Design Specifications. Performance specifications define what the product or service must do but not its design. When performance specifications are used, the process is commonly referred to as black box sourcing, and the supplier has maximum latitude to determine how to achieve the required performance. The buyer focuses on results as captured by the performance specifications, leaving the details of how to attain these results up to the supplier. For example, an auto assembler such as General Motors uses performance specifications for the navigation systems in its vehicles. Performance specifications also are often used for capital equipment. When performance specifications are used, the supplier assumes all responsibility for the product’s or service’s performance.

This approach typically is referred to as white box sourcing and is used in situations where the buying organization has stronger design capabilities than its suppliers, the interface with other suppliers’ parts and components is critical for quality and performance, or when strict control is needed (for example, to ensure product safety). When using design specifications, the buying organization assumes the risk for proper performance. For example, a pharmaceutical product is likely to be sourced using design specifications.

Statement (or Scope) of Work (SOW). For services, a statement (or scope) of work (SOW) document is used to communicate needs to suppliers. An SOW “describes the nature and extent of the work to be performed and outlines the conditions under which the work is to be performed” (ISM Glossary 6th edition). An SOW should include a definition of the work to be done, the time frame, the boundaries of the work, the expected results, and how the supplier’s performance will be evaluated. For more complex projects, such as an ERP implementation or human resources outsourcing, an SOW should also include a work breakdown structure, which breaks the project into smaller subsegments to facilitate project management.

When a large service contract is broken down into smaller segments, the continuation of the overall contract may be contingent upon the successful completion of each segment. After the completion of a segment, a quality assessment may take place to explicitly acknowledge that the SOW has been met to that point. When several dependent segments merge to one point in the progression of a service project, it is called a hold point or a milestone. Approval must be granted before the work proceeds. The hold points or milestones are put in place to control deviations that occur during the project.

Other Types of Specifications. Internal specifications are developed by an organization for its own use. External specifications are developed by industry associations or governmental agencies. For example, ASTM International is a source of standards for metals, plastics, textiles, and a wide range of other materials and processes. Internal and external specifications should overlap as closely as possible. Using specifications based on industry standards generally means that there will be more qualified suppliers for products or services, which increases competition and lowers prices.⁴ External standards simplify communication with suppliers. Both the buyer and supplier organizations should mutually understand what is desired as well as how performance against the specifications will be measured.

In some cases, when characteristics such as color, texture, flavor, or aroma are needed, a sample is the best way to communicate the requirements. For example, think about sourcing a textured, floral fabric to be used for upholstered furniture. It would be much easier to provide a sample than to try to develop written specifications describing the fabric. When a physical sample is used to communicate specifications, the contract terms state that other products should be produced just like the sample. Often, services also can be sampled. Once the buying organization samples a service process, such as a training class or a catering operation, it may document the key characteristics of the sample and request that subsequent services duplicate it.