4.3Procurement and contract types

The starting point of procurement management is make-or-buy analysis, which judges whether work should be outsourced at all. Once outsourcing is decided, the next crucial judgment is choosing a contract type. Which party—the buyer or the vendor—bears the risk of cost overrun differs fundamentally by contract type, and the optimal contract type shifts depending on how firm the requirements are (certainty). This section compares contract types along the consistent axis of risk-bearing, building judgment for choosing among them based on the situation.

4.3.1Make-or-buy analysis

• Make-or-buy analysis compares whether a given product or service should be developed/performed internally within one's own organization, or procured (purchased, outsourced) externally, weighing factors such as cost, schedule, in-house know-how, and strategic importance (core competence). Beyond a simple cost comparison, whether the product or service touches the organization's core competitive strength (core competence) is an important criterion.
• Casually outsourcing an area that directly touches core competence carries the risk that know-how never accumulates in-house, eroding competitive strength over time. Conversely, continuing to build a non-core area internally often results in inferior quality and cost compared to a specialized external vendor. Make-or-buy analysis is not a one-time decision—it is re-evaluated at every project phase or scope change.

4.3.2Contract types and risk-bearing

• Fixed-price (FP) contracts fix the total amount in advance regardless of the actual work performed. If actual cost exceeds the estimate, the vendor absorbs the overrun, making this contract type carry high risk for the vendor. The buyer gains high budget predictability, but if requirements change, the vendor has an incentive to respond with added cost or reduced quality. It suits engagements where requirements are clearly firm.
• Cost-reimbursable (cost-plus) contracts pay the actual costs incurred (cost) plus a markup for the vendor's profit (fee). Because the vendor can recover its actual costs even if cost overruns occur, the risk of cost overrun falls on the buyer. This suits exploratory or R&D-oriented engagements where requirements are not yet firm and the scope of work is difficult to estimate in advance. Time-and-materials (T&M) contracts pay based on labor time (an hourly/per-person rate) and the actual cost of materials used, carrying risk-bearing intermediate between fixed-price and cost-reimbursable (suited to small-scale, short-duration add-on work, or engagements whose scope is only partially unclear).

Suppose a PM is about to outsource exploratory development of an AI model, as a proof-of-concept (PoC) for a new business, to an external vendor. The requirements are at a stage where "there is a rough sense of the accuracy target, but which algorithm and data preprocessing will work must be discovered through trial and error as development proceeds"—the scope cannot be accurately estimated at the outset. If the PM reasons "let's use a fixed-price contract to avoid the risk of budget overrun," that seems sensible at first glance but is actually a dangerous misjudgment. Because a fixed-price contract makes the vendor absorb any cost overrun, placing a fixed-price order with a vendor while requirements remain unsettled means the vendor, every time unexpected trial-and-error occurs, will be pushed to strip features to stay within the contracted scope, or to repeatedly request contract changes (billing for additional cost). The result is a loss of the exploratory flexibility originally hoped for, and a real risk of more rework and friction, not less. What the PM should choose in this case is a cost-reimbursable (cost-plus) contract. Paying the actual development effort and trial-and-error cost incurred means the vendor need not engage in rigid contract renegotiation every time scope shifts, and can pursue the exploration flexibly. The buyer does need to continuously monitor both progress and actual cost to manage the risk of overrun, but this is a controllable risk compared to the risk of vendor demoralization and quality degradation that a fixed-price contract would invite here. Conversely, once the PoC results firm up the requirements for the subsequent full-development phase, switching to a fixed-price contract is rational, because the scope is now settled—the central judgment axis of this section is that the contract type is something to be reassessed as the project progresses and requirement certainty changes.

4.3.3Section summary

• Make-or-buy analysis weighs core-competence involvement alongside cost, and is re-evaluated at every phase
• A fixed-price contract carries high vendor risk and suits engagements with firm requirements; a cost-reimbursable contract carries high buyer risk and suits exploratory engagements
• The contract type is not fixed—it must be reassessed as requirement certainty changes (from an exploratory phase to a full-development phase)