1

Chapter 15

Contract Management

IDIS 424Spring 2004

2

The Contracting Process

Request for Quotation

Supplier’s Proposal

Contract BuildingNegotiation

Contract Award (P.O.)

Contract Administration

3

Request for Quotation

Standard terms and conditions of the transaction Quantity / conditions of delivery End use of the item If customized - review with legal counsel If competitive bid, manner and time period in which

bids evaluated Services - not covered under UCC Review seller’s acknowledgements carefully RFQ is not an offer, but request for price and

availability

4

The Purchase Order Contract

UCC can be relied on to cover all important terms except: A description of the parties involved A description of the basic subject of the

contract and statement of work including dates A clearly definable or determinable quantity

PO is not a contract - is an offer, which becomes a contract when accepted

5

Purchase Order Terms

Fixed prices and quantities (incl. taxes) Buyer’s right of inspection and rejection Right to make spec./ design changes Holding buyer harmless - patent infringement Supplier’s right to assign contract to third party Instructions re: risk of loss

6

Boiler Plate Terms

Statement of credit and payment terms Identification Packing and Preparation Statements of Warranty Shipment quantities / dates Assignment of seller’s rights Arbitration clause Sometimes - right to cancel unshipped portion

7

Limit Liabilities and Indemnity!

“Limit liability” = hold harmless “Indemnify” = exempt” In acknowledging a purchase order, a supplier

may impose the following clause: “The parties agree that the buyer’s sole and

exclusive remedy against the seller shall be for the repair or replacement of defective parts, etc.. . . the buyer agrees that no remedy, including but not limited to, incidental damages, for any lost profits, etc., shall be available to him/her.”

8

Pricing

Contracts do not need to specify a price to be valid (avoid this practice if possible)

Escalation clause - indexed to a commodity index

Price at time of delivery Surcharges Cost-plus scenario Progressive prices

9

When to Negotiate

Many variables affect price, quality, and service Business risks cannot be predetermined Early supplier involvement in new product

development Contracting for supplier’s productive capacity Tooling and setup are large percentage of cost

10

When to Negotiate

Long lead-times (price adjustment clauses) Many engineering changes Thorough analysis of make or buy involved No other competitive supplier

11

Conflicting Terms

Typewritten insertions in a contract or purchase order take precedence over printed items.

Handwritten insertions supersede typed or preprinted items.

A conflict between a spelled out number and one that is a different numeral is resolved in favor of the number that is spelled out.

Conflicts between terms and clauses are resolved in favor of the one appearing first in the document.

Ambiguities are interpreted against the party inserting the term in question.

12

Blanket Orders

Should contain terms and conditions Cover several shipments into the future Releases should not have terms and conditions If purchase orders are issued, then it should be as a

release against blanket order

13

“Battle of the Forms”

Seller acknowledges receipt by transmitting a standard form with conflicting terms and conditions

Buyer’s terms are superseded Supplier may send volumes of printed

acknowledgements with differing terms Supplier can change price on an issued PO How to cope?

14

“Battling the Battle of the Forms”

Include reconciliation of purchase order terms in agenda of negotiable items

State that “offer is accepted when acknowledgement form is received”

Conduct = shipment and acceptance of goods Establish procedures for larger commitments Use good judgement! Involve affected functional members

15

Accepting Orders Occurs When:

After a reasonable opportunity to inspect the goods, the buyer signifies that the goods are conforming or that he will take them in spite of non-conformity

buyer fails to make an effective rejection. . . does not occur until the buyer has had a reasonable opportunity to inspect them

does any act inconsistent with the seller’s ownership

16

Purchaser’s Acceptance

After point of acceptance, purchaser cannot send back goods unless supplier consents

Purchaser’s obligations Prove goods did not conform to contract Notify supplier of breach of contract

17

Acceptance - Example

A buyer and a supplier have been doing business for several years. During the pas t year, approximately one-third of the shipments from the supplier arrived a week or so late, but the buyer accepted them without serious complaints. In the eyes of the law, these acceptances by the buyer may well have set a precedent which waives the buyer’s rights to timely delivery on future contracts!

18

To Prevent Problems:

Stamp"Received Subject to Inspection, Count, and Testing".

PO Terms and conditions Inspect upon delivery. Stock rotation Define “reasonable time” (check with people in

trade) Good internal reporting Production equipment clause Software and services - define “acceptable”

19

Contracts and EDI

Signed contract will not accompany EDI transmission

Need a separate contract with key terms: PO’s transmitted electronically Authorize 3rd party network to interchange data Identify shipment and receiving locations Return functional acknowledgements of documents Company terms of condition, are made applicable to

all electronic POs Specified duration of contract Responsibility for third party network cost Document transaction standards

20

Cancellation of Orders

Cancellation for default Cancellation for convenience of

purchaser (anticipatory breach” Cancellation by mutual consent

21

Liability for Breach of Contract

Occurs when someone cannot or will not perform their contract obligations and there is no valid or legal justification or excuse for this failure

Mimi’s wholesale video store and Betsy now have a valid contract. Betsy has promised to buy 1,000 videotapes for $15 apiece, and Mimi has promised to deliver them to Betsy’s place of business on February 1. However, Mimi never shows up.

22

Breach of Contract?

On January 1, Betsy and Mimi’s wholesale video store form a valid contract. Betsy promises to buy 1,000 videos for $15 apiece, and Mimi promises to deliver them to Betsy’s place of business on December 31, almost a year later. However, on January 2, Mimi calls Betsy and tells her that she won’t deliver the tapes, because she has suddenly decided to close her business and move to Japan. Betsy runs a retail video business, and with this particular store Betsy has to plan her inventory well in advance. Therefore, long before December 31, Betsy calls another wholesaler. Betsy has to pay the other wholesaler more than she agree to pay Mimi for the videotapes, so Betsy now wants to sue Mimi. Can she sue?

23

Damages

Actual damages - losses that are real, known, or can be estimated

Punitive damages - extra money over and above actual damages must be paid by the losing defendant to the plaintiff as punishment for the defendant’s particularly bad behavior

24

Calculating Actual Damages

Restitution - Money the plaintiff actually paid to the defendant in connection with the contract

Reliance - Money that the plaintiff lost because he or she was relying on the contract, depending on the defendant to live up to the defendant’s obligations under the contract

Expectancy - Money the plaintiff was hoping to gain from the contract

25

Back at Mimi’s Store. . .

Mimi’s wholesale video store and Betsy had a valid contract. Betsy promised to buy 1,000 videotapes for $15 apiece, and Mimi promised to deliver them to Betsy’s place of business. Betsy gave Mimi $2,000 as a downpayment on the delivery. Betsy also spent $5,000 building new shelves in her retail video store to hold the tapes. Finally, Betsy expected to make a profit of $20,000 after expenses from selling and/or renting the tapes to her customers. However, Mimi never delivers the tapes, and Betsy sues for breach of contract. What damages is she entitled to?

26

Other Clauses

Penalty Clauses (Illegal!) Should be called “incentive clauses” or

“liquidated damages” Difference - documentation of reasonable

relationship between expectations and clauses Governing Clause - state where law will

interpret Forum Clause - describes where legal

action will be brought Exculpatory clause

27

Enforcing a Contract

Unconscionable Contracts Fraudulent Contracts Statue of Frauds Illegal Contracts Lack of Capacity State of Limitations Violation of Consumer Protection Laws

28

Intellectual Property

Cannot rely on UCC to cover: Patents Trademarks and Service marks Copyrights

29

Patents

Gives holder exclusive rights to profit from the use of “any new and useful process, machine, manufacture or composition of matter or any new and useful improvement thereof.”

Utility patents - protects substantive, functional nature of a new invention, and gives the holder 17 years of exclusive rights

Design patents - protects ornamental, non-substantive creations for 14 years

30

You cannot patent:

Newly discovered scientific principles New ideas or mental processes Newly discovered elements or other natural

substances New methods of conducting business Items that should be protected under other

federal laws, such as writings

31

Patent Infringement

Patent holder can sue if the other party does one of two things:

Uses the patent holder’s invention without the patent holder’s consent

Uses technology that is marginally different from the patent holder’s new invention but is, in essence, equivalent

32

Types of Patent Infringement

Direct infringement - illegally using or selling a machine or invention

Active inducement to infringement - aiding and abetting another party’s act of patent infringement

Contributory infringement - cooperating in the sale of components of the patented machine, device or other items

33

Patent Indemnification Clauses

Supplier assures that the goods being contracted for do not infringe on any other party's patents.

Right to require the supplier to defend any patent infringement suit itself.

Purchaser retains the right to have its own attorneys involved in defense of any lawsuit concerning patent infringement

34

Trademarks and Copyrights

Trademark: “Any word,name, symbol, device,or any combination thereof used to identify goods

Copyright - Affords protection for creators of original works

Rights of reproduction, preparation of derivative works, public distribution, performance, and display

Ownership - life of author + fifty years

35

Trade Secrets

Information which is economically valuable not generally known kept as a secret

Nondisclosure agreement or trade secrets clause

36

GET IT IN WRITING!

Contract is NOT a physical thing, but a relationship which exists between parties

Written document is only evidence of the contract Verbal contracts are just as binding as a written one in

court When reduced to writing, written evidence supersedes all

prior oral evidence For sales transactions > $500, contract must be reduced to

writing to be enforceable All data to be included should appear above agent’s

signature

37

Action Description

Legal Action File a lawsuit in a federal/state/local court.

Non-legal actions

Arbitration Use of an impartial third party to settle a contractual dispute

Mediation Intervention by a third party to promote settlement, reconciliation,or compromise between parties involved in a contractual dispute.

“Mini-trial” An exchange of information between managers in eachorganization, followed by negotiation between executives fromeach organization.

“Rent-a-judge” A neutral party conducts a “trial” between the parties, and isresponsible for the final judgement.

Contract Conflict Resolution

38

Arbitration

Arbitration - renders a final decision which is binding

Can have an arbitration clause which reserves right to appeal

Higher Authority clause - “you may not go to arbitration until two levels of higher authority have reviewed the dispute”

39

Issues to Consider

State of Limitations (2 yrs - UCC, 4 yrs - Contract law)

Status of relationship Desired Outcomes Level of Involvement Level of Emotion Speed of resolution Information requirements

40

Litigation Considerations

Going through state or federal courts should be decided by lawyers (based on previous cases)

Issue should be >$50K if considering federal course

Services not governed by UCC Better to process litigation under UCC

rather than general contract law (stricter)

41

Fixed Price Contracts

Firm fixed price No price adjustment due to supplier's cost

experience Fixed-price with Economic Price

Adjustment Contracts Recognize economic contingencies, such as

unstable labor or market conditions EPA recognizes both inflation and deflation Cost elements include RM, components, and

direct labor

42

Fixed Price Contracts

Fixed-Price Redetermination Fixed price for initial contract period with

an upward or downward redetermination at a stated time.

43

Incentive Arrangements

Applied to motivate the supplier to improve cost, schedule or other parameters

Target cost = most likely cost Target profit = "fair and reasonable" Sharing arrangement = how to share

cost responsibility

44

Incentive Arrangements

Fixed-price Incentive contract Final amount the supplier receives is

limited by the ceiling price Cost-Plus-Incentive-Fee Arrangement

Incentive in the form of sharing above and below target cost

Below target customer(75) / supplier (25), Above target customer (87.5) / supplier (12.5))

45

Cost-based Contracts

Cost reimbursement Customer agrees to reimburse all

allowable costs, but no fee is paid. Often used for contracts with educational

institutions

46

Cost-based Contracts

Cost sharing Customer agrees to reimburse supplier for a

predetermined portion of the allowable costs Supplier agrees to absorb part of costs in the

expectation of subsequent compensating benefits (i.e. right to sell to other firms)

Often used for procurement of basic and applied research

47

Cost-based Contracts

Time and Materials Buy labor at fixed hourly rate that includes

direct labor, indirect costs and profit, and materials at cost.

Often used for repair and overhaul services

48

Cost-based Contracts

Cost-Plus-Fixed-Fee Arrangement Buyer agrees to reimburse supplier for ALL

allocable, allowable, and reasonable costs incurred during performance of contract

Used in high-risk projects, such as research or exploratory development

49

Cost-based Contracts

Cost-Plus-Award-Fee Arrangement Award fee based upon periodic evaluations

of ongoing supplier performance

50

Contract Writing Guidelines

Generic Terms Incorporation by Reference Negotiable Clauses Notices Order of Precedence Purchase Order Scope of Work

51

Contract Writing Guidelines

Signatures Small Value Contracts Statement of Work Warranty

52

International Contracts

Typically governed by CISG standards Okay for buyer and seller to agree that CISG

not govern the contract Governing law clause - addresses government

to settle dispute Currency exchange clauses can be used to

identify “trigger points”

53

Service Contracts- IS Systems

The length of the proposed agreement; The role of company growth or downsizing; Service provider defaults or contract

amendments; Data security; Control of outsourcing costs; and Control of information systems operations.

54

Service Contracts

Independent contract clause - states that any on-site suppliers are acting as an independent contractor and not as an employee of the company

If accident occurs due to contractor negligence, company will not be liable

55

Issues to Consider

Level of Service Price Acceptance criteria System Implementation Control Procedures Requirements Can add a clause that requires service to be

considered as goods under UCC Section 2

56

Capital Equipment

Do not use FOB Rely on title, risk of loss and warranty (after

first $1) Supplier should be responsible until

installation is complete and machine is operating properly

Warranty begins once machine is operating

57

Furniture / Tooling

Should be marked as property of . . . To avoid problems recovering goods at a

supplier’s warehouse, identify all tooling, etc.

Avoids having to go to court if supplier goes into bankruptcy

58

Longer-Term Contracting

59

Supplier Contracting

Firms often enter into longer-term agreements with the suppliers they expect to do business with over an extended period of time

Longer-term agreements are Legal contracts between two or more parties

that are expected to be in effect for a time period greater than a year, and which usually address a greater range of price and non-price issues than shorter-term or standard “boiler-plate” agreements

60

Supplier Contracting

Issues to consider when determining the appropriate type of contract -- Market uncertainty Industry practices Desired length of the agreement Outcomes sought from the agreement Relationship between contracting parties Process or technological uncertainty Supplier’s impact on cost or other performance variables Total dollar value of the agreement Cost versus priced based approaches (recall the portfolio

matrix approach)

61

Supplier Contracting

Growth in Longer-Term Contracting-- The percentage of longer-term contracts to

total contracts has increased 50% since 1990, from 24% of total contracts to 36% currently

The dollar value of purchases represented by longer-term contracts has increased almost 47%, from 34% to 50% of total purchase dollarsSource: Monczka and Trent, Purchasing and Supply Management:

Key Trends and Changes, 1998

62

Supplier Contracting

Enter a longer-term agreement only after answering the following question!!!

What benefits can a longer-term agreement provide that are not

available withconventional purchase

agreements?

What benefits can a longer-term agreement provide that are not

available withconventional purchase

agreements?

63

Supplier Contracting

What are the benefits a firm hopes to attain by pursuing longer-term purchase agreements?

Let’ discuss!

64

Supplier Contracting

What are the risks to longer-term contracting?

__________________________ __________________________ __________________________ __________________________ __________________________ __________________________ __________________________ __________________________

65

Supplier Contracting

So, you think longer-term contracts are just purchase contracts with a longer time frame? Well, consider a single contractual issue called price/cost…..

How was I to know?

66

Supplier Contracting

Consider the contract possibilities relating to price/cost-- Firm fixed price Fixed price with escalation/de-escalation formulas Fixed price with re-determination Fixed price with incentives Cost plus incentive fee Cost-sharing Time and materials contract Cost plus fixed fee

67

Purchasing Ethics

68

Ethical Behavior

Use of recognized social principles involving justice and fairness throughout our business relationships.

An ethical buyer treats sellers in a just, decent, fair, honest, and fitting manner.

Following a code viewed as fair by those within the profession, as well as the community.

69

Rules of Thumb

Buyer must commit his or her attention and energies for the organization's benefit rather than personal enrichment at the expense of the organization.

A buyer must act ethically towards suppliers or potential suppliers

Uphold the ethical standards set forth by the purchasing profession

70

Pressures for Purchasers

Have control over large sums of money Pressure on sales people to sell! Easy to justify behavior “What’s wrong with a free lunch?”

71

Risks of Unethical Behavior

Legal risk Personal risk Company risk

72

Perceived Ethical Issue Confronts Buyer

Organizational Environment

Cultural Environment

Personal Experiences

Industry Environment

Variables Affecting Buyer’s Ethical Perspective

Judgement Rendered by Buyer

Buyer Behavior

73

Types of Unethical Behavior

Reciprocity Personal Buying Accepting Supplier Favors Sharp Practices Financial Conflicts of Interest

74

Reciprocity

Giving preferential treatment to suppliers who are also customers

Can take on a coercive nature Can hurt morale of supplier’s purchasing

dept. Federal Trade Commission Rules

75

Personal Buying

Purchasing dept. purchases material for the personal needs of its employees

“Trade diversion laws” in some states Exceptions: safety shoes, hats, gloves,

special tools “Gray area”

76

Accepting Supplier Favors

Most common ethical infraction Giving preferential treatment and privileged

information in return What may a buyer accept from a supplier?

77

Sharp Practices

Willful use of information Exaggerating problems Requesting bids from unqualified suppliers Gaining information unfairly Sharing information on competitive bids Not compensating for design work Taking unfair advantage of financial situation Lying or misleading

78

Financial Conflicts of Interest

Buyer awards business to a supplier because the buyer, buyer’s family, or relatives have a direct financial interest in the supplier

Avoided if employees required to detail investments in outside companies

Serious breach of ethics Similar to an executive buying or selling

stocks with inside knowledge

79

NAPM Code of Ethics

1. To consider, first, the interest of your company in all transactions and to carry out and believe in its established policies

2. To be receptive to competent counsel from your colleagues and to be guided by such counsel without impairing the dignity and responsibility of your office

3. To buy without prejudice, seeking to obtain the maximum value for each dollar of expenditure

4. To strive consistently for knowledge of the materials and processes of manufacture, and to establish practical methods for the conduct of office

5. To subscribe to and work for honesty and truth in buying and selling, and to denounce all forms and manifestations of commercial bribery

80

NAPM Code of Ethics

6. To accord a prompt and courteous reception, so far as conditions will permit, to all who call on a legitimate business mission

7. To respect your obligations and to require that obligations to you and to your concern be respected, consistent with good business practice

8. To avoid sharp practice

9. To counsel and assist fellow purchasing managers in the performance of their duties, whenever occasion permits

10.To cooperate with all organizations and individuals engaged in activities designed to enhance the development and standing of purchasing

81

Survey of Supplier Favors

Exhibit 7Supplier Favors and Acceptance

Offered to Accepted by Acceptable toDescription Buyers(1) Buyers(2) Buyers(3) Lunches 83% 75% 68%Dinners 67% 51% 48%Holiday Gifts 67% 47% 43%Event Tickets 57% 38% 37%Trips to Supplier's Plant 51% 30% 31%Food and Liquor 46% 25% 28%Golf Outings 43% 25% 28%Advertising Souvenirs 26% 26% 72%Discounts on personal Purchases 24% 9% 11%Small Value Appliances 19% 7% 6%Clothing 11% 6% 7%Vacation Trips 10% 2% 2%Large Appliances 4% .4% 1%Loans of Money 3% 0% 1%Automobiles 2% .4% 1%

N=236 respondents

(1) Percentage of survey respondents indicating a particular item had been offered bya supplier

(2) Percentage of survey respondents indicating they had actually accepted aparticular item

(3) Percentage of survey respondents indicating that acceptance of a particular itemdid not pose an ethical problem

Source: Center for Advanced Purchasing Studies 1988

82

Supporting Ethical Behavior

Develop a Statement of Ethics Top management commitment Closer buyer-seller relationships Ethical training and education Develop consistent behavior within a firm Internal reporting of unethical behavior