When you hire someone to do work or to deliver a product, you expect them to do it right, and they expect to be paid. When transactions are simple, such as the purchase of fuel at a gas station, there is no confusion about whether the services were delivered or the right amount paid.
However, complex purchases (procurements) are not so easy to assess. Contracts become necessary when there is uncertainty about who will do what (scope), by when (schedule), and for how much (cost). They are used to clarify expectations and to define mechanisms for problem resolution in the event of misunderstanding that leads to conflict.
Contracts are meant to solidify/clarify/explain commitments on both sides of an agreement. Contracts should state exactly what the seller will do or deliver, and when, as well as what consideration the buyer will provide (and when) in exchange for those goods and services.
Allocation of Risk
Contracts clarify the allocation of risk: “If this happens, it’s your problem; if that happens, it’s my problem.”
Contracts explain what actions will be taken under various future outcomes so that there is no confusion about how problems will be resolved.
Contracts do not keep people honest. They do not prevent fraud and criminal behavior. They just provide a method of recourse (the courts) in the event of dishonest behavior or disagreement between the parties (honest or not).
Transfer of Responsibility
From a practical perspective, contracts are used in business to ensure that responsibilities are transferred in exchange for benefits. For example, if I hire someone to do work and I pay them in advance, without a contract in place, then I am taking a chance of the work not getting done and the money being lost. If the ‘contractor’ does not complete the work for which they were paid, how can I prove that they were paid or show what the payment was for if there is no contract?
On the other hand, if I hire someone to do work and commit to paying them in arrears (after the work), but there is no contract in place, they take a chance on doing the work and not getting paid.
What a contract does is document the commitments on both sides. Agreements and commitments are written down before the work begins. If either side fails to live up to their promises, the dispute can be resolved using the courts.
Risk transfer (from a buyer’s perspective) means making someone else responsible in exchange for payment. If the buyer wanted to transfer all of the risks to a vendor (schedule, scope, and cost inflation), they would need to find a vendor willing to sign a contract for a fixed price, with clearly defined scope and a rigid completion date.
Of course, the contractor would need to be well-paid to accept all of these risks. Buyers are able to transfer risk, but it is not free.
So, if a company decides to do the work themselves (internally), they retain all the risks. However, if they choose to contract out the work, they are able to transfer some portion of the risk in exchange for financial reward. BUT, and this is a big but, risks are not effectively transferred from a buyer to a seller unless there is a legally enforceable contract in place to ensure that the right work gets done, gets done properly, and gets done on time. This is where experience and the legal department come in.