Contracts have long been considered fixed instruments with clear mandates and harsh consequences for failure to comply. For years, there was an unwavering rigidity in the way that contracts were negotiated, drafted, and managed. The idea was for parties to recognize the contractually written obligations as fixed, with the rules for performance clearly stated and necessitating near perfect obedience. In general, the price, scope, and duration of the contract were clearly defined, and there was little room, if any, for deviations.
Although this traditional contracting approach still exists, there is an increasing movement away from such stringency, as adherence to these rigorous principles has led to costly and time-consuming contract disputes. Rather than spend enormous amounts of time on negotiations and dispute resolution, there is recognition that the parties should focus on collaboration and results-oriented action. This is generally known as agile contracting, and it is changing the way in which contracts are negotiated, drafted, and most importantly, managed. Here are three common types of agile contracts:
In a target cost contract, the parties agree on a final price for the delivery of a product or service. This price has to be realistic and takes into consideration the supplier’s costs to produce the good or service, includes the supplier’s fee which is based on its general overhead, and accounts for the risk to the supplier. The underlying goal of this sort of contract is to incentivize the supplier to fulfill the contract at a lower cost than the target cost.
In the event that the supplier is able to spend less than the targeted cost, both parties to the agreement will share in the savings. However, in the event that the supplier exceeds the targeted cost, both parties will share the financial burden. This is known as the pain or gain mechanism. The mutual savings in the underspend scenario, or the shared contributions in the overspend scenario, are meant to keep the overall cost of the contract down.
If the supplier had to assume all of the risk, then the projected target cost would likely be much higher. However, given that both parties will essentially be jointly penalized for any cost overrun, the supplier can accommodate a lower target point. In addition, there is an actual financial incentive to work more efficiently and find opportunities for cost savings. Although there is a target cost, there is built in flexibility and the avoidance of overly harsh repercussions, which is the very core of an agile contract.
In an incremental delivery contract, there are predetermined review points written into the agreement. This basically allows a longer project to be broken up into several distinct mini projects. At each review point, the parties can evaluate performance up to that point and decide whether they wish to modify the arrangement, continue as planned, or terminate altogether. This method is commonly used for the development of software and other technological tools, as the incremental approach allows for a gradual building of the needed product.
Of course, it would be unfair for the supplier to create something for which they are never compensated, so the idea is for the most valuable components of the system to be provided for immediate use and benefit. Then, each subsequent increment will simply add other features and tools, thus continuing to enhance the overall value of the particular product. This again incorporates a great deal of flexibility and allows for ongoing improvements rather than a fixed timeline with concrete requirements.
Time and Materials
Perhaps the simplest of the agile contracts is the time and materials agreement. This sort of contract works precisely as it sounds in that the supplier is paid for the time spent creating a product or delivering a service as well as for the materials that were used in its creation and delivery. Obviously, the supplier will want to ensure that it utilizes its time and materials in an efficient manner to keep the overall costs of the contract as low as possible since this will help preserve the longevity of the contracting relationship.
In some cases, the parties may wish to implement a capped form of this agreement, so that the total cost is capped at a certain point. This further encourages efficiency and protects the purchaser from any potentially excessive cost overruns. Granted, the capped version stifles the flexibility and thus agility associated with a time and materials contract, but it is still less rigid than the traditional fixed price, scope, or duration type of agreement.