Contracts are a very important aspect to our economy and international business alike. In our economy they create sticky prices, and internationally they can help build or deteriorate relationships.
There are two types of contracts: Cost plus and Fixed price. In cost plus you can choose a cost plus fixed fee, incentive fee, or award fee. In fixed price contracts you can choose between a fixed price, or an incentive fee.
Cost contracts are used when performance risk is high. For example incentive contracts provide more money to the contractor or builder if a schedule is met, total cost is lower, quality higher, along with other task related measuring sticks. This example if from Wikipedia:
Assume a cost-plus incentive fee contract is signed with the following characteristics:
- Total cost: $10,000
- Profit margin: $0.15 per dollar
- Incentive fee: $0.45 per dollar
The contractor will make $0.15 for every dollar spent (each dollar of expense is paid for, plus $0.15 profit). If the contractor finishes work with an actual cost under $10,000, then they are awarded $0.45 per dollar saved. The bonus in this example is worth 3 times as much per dollar, thus providing an incentive for the contractor to finish the job under budget.
- If the actual cost is $15,000, the contractor earns a profit of $2,250.
- If the actual cost is $10,000, the contractor earns a profit of $1,500.
- If the actual cost is $5,000, the contractor earns a profit of $3,000. ($750 base profit + $2,250 from the incentive fee).
On the other hand award contracts are subjective evaluations of performance. Due to both of these variants, the contractor’s profits are usually protected, direct and indirect costs are indeed an issue and in many cases cost collection systems may be sophisticated. Why? Well because it is all dependant on evaluation…
Fixed Price contracts are used when performance risk is low. These incentive fee fixed price contracts are used to accomplish specific objectives. The cost is very manageable by the purchaser and contractors can achieve greater profits depended on a greater performance.
Now deciding which contract to pursue in the business arena can be tricky. Some street smart advice is to not take a contract that requires extraordinary performance and not to take an award contract unless you trust the buyer.
When dealing with international contracts it is important to keep contracts bilingual and it is always important to bring your own translator. Trusting the locals is dangerous because they will try to benefit the local company through their position. Also, be prepared for technology transfer regulations. This requires separate documentation and is very important. With contractual international agreements you should have written agreements signed by all parties related to all aspects of payments for services rendered in advance, and also understand how money will be transacted between countries.
Keep in mind though, if the enforcement of a contract in a foreign country is unlikely, due to the lack of a formal legal system, then why have a contract?
*Sources: ISE, Dr. Meredith