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Effective Contracting

An important and immediate opportunity exists to better align incentives and share risks through restructuring contractual arrangements. Effective contracting is also critical for ensuring that pooled purchasing mechanisms, which are being considered by many funders, achieve their objectives. However, global health funders in general have made only limited use of the wide range of risk-sharing arrangements.

No single contracting option is optimal across all types of products and situations. Rather a range of approaches (below) could and should be considered which shift the current risk allocation in which funders, procurement agents and national buyers accept little or no risk, while suppliers gear their decisions about pricing and investments in capacity to a market in which they face significant, unshared risk.

Minimum purchase commitments require that a buyer agrees in advance to purchase a specified quantity of product, either in a single transaction or over a period of time. By accepting some of the supplier's risk for production, the buyer has an incentive to accurately forecast demand. Typically, suppliers offer incentives to buyers to take on this risk through reduced prices for the minimum purchase commitment. Suppliers are not committed to producing above the specified amounts, so this arrangement works best for the purchaser in cases where the long term market demand is stable, there are substitutes available that prevent stock-out risk, or there are opportunities to off-load excess inventory.

When demand is highly uncertain, quantity flexibility contracts allow the buyer to commit to a minimum amount at a certain price while retaining the flexibility to purchase more product to guard against the consequences of stock-outs by binding the supplier to make a specified quantity of product above that amount available at a premium price if additional demand arises. Suppliers may be interested in these types of contracts if the marginal cost of production is low, but the base set up costs are high; if there are multiple suppliers; or if there is uncertainty about which supplier a purchaser will select. The contract may also allow suppliers to collaborate to buy and sell excess inventory, which limits each supplier's individual risk.

Buyback contracts are useful in situations where demand is unstable but the risk of stock out is asymmetrically distributed among the stakeholders and has significant public health consequences. They are often used when the production cycle is long and it is difficult to scale up supply rapidly if demand is higher than expected or where the presence of supply can stimulate demand.

Like buyback contracts, revenue sharing is useful in situations where demand is uncertain but the presence of the product stimulates demand. This mechanism also encourages the sharing of demand and supply information between purchasers and suppliers. Revenue sharing passes risk to the supplier, but also aligns supplier and retailer incentives and encourages suppliers to produce sufficient levels of supply. When this system works well, suppliers get timely information about actual sales since they share in the profits generated by those sales and can adjust production capacity accordingly.

Real options protect buyers against price uncertainty. An option gives the buyer the right (but not the obligation) to take some action at a future time for a predetermined price. Real options involve the actual sale and purchase of goods if and when the option is exercised. An option is defined by the option price (upfront price paid to acquire the option), exercise price (price at which product can be purchased if the option is exercised) and an exercise date (typically a date range). A common form of real-options contracts involves the buyer making firm commitments to the manufacturer for future year purchases (years 1, 2, 3) for a certain amount of product and purchasing an option to buy additional units at predetermined prices in years 2 and 3. Based on observed demand in the first year, the buyer decides whether or not to exercise the option in the second and third years.