Costs and price are often the most hotly debated area when the buyer and supplier negotiate with each other. Drafting suitable pricing appendix will prompt supplier to focus more on cost management rather than charging the buyer unnecessary expense. In this series, we examine different pricing arrangements, when you should apply it and how to manage supplier’s performance with these arrangement.
Schedule of rate
Schedule of rate is a schedule in which unit price of each item is listed. The total price is calculated by summing up the units used in the project.
Schedule of rate is commonly used in professional service contracts (such as consultancy or legal services) under the form of hourly rate and in maintenance contracts.
The major disadvantage of schedule of rate is that the service provider has no incentive to limit and control the expense. If the buyer approaches in laissez-faire way, the supplier may perform unnecessary work or lengthen the project which will cost buyer more. To control spend under schedule of rate, the buyer should:
- Research carefully about the scope of the project
- Consult the market price of the items to be used in the project
- Require the provider to indemnify or purchase suitable insurance policies.
- Clarify to the service provider that they should ‘work to a price’. If the actual results cost more than pre-defined price, the additional units should be charged differently, normally at a reduced price.
Fixed price contract
Fixed price is very common in purchasing goods and services. This type of arrangement is mostly used in one-off purchase of goods or short-term services.
Since the contract price is fixed, the buyer enjoys a level of certainty in budgeting. However, the risk of overspending still persists if the goods/services do not meet the requirements. Therefore, testing should be a part of fixed price contract.
Variable pricing contract
Variable pricing contract is the contract in which the price of the goods changes frequently based on third party’s indexation. This type of contract may apply to long-term supply of raw materials or components.
Normally, the parties write a simple formula to calculate the unit price to be paid. For example, in supply contract of raw materials, the buyer and supplier agree to calculate the unit price at the end of the month as following:
U is the unit price
U0 is the base unit price
k is the coefficient
PPIn is the producer price index published by government’s statistical office in the n-th month from the contract
PPI0 is the based producer price index published by government’s statistical office in the beginning month of the contract
Variable pricing strikes a balance between the buyer and the supplier. The buyer may enjoy favourable price when the market price falls. But they also incur higher price when the market price soars. Budgeting in variable pricing contract is not easy as fixed pricing. The buyer must predict the market trend and allocate the budget accordingly. Therefore, to manage this type of contract, knowledge of market and market trends is necessary. The buyer should recruit someone who has appropriate competency.