Contracts – who needs them!

As we all know, a contract only has real purpose when things go wrong. That’s why organizations engage in a battle over whose form will prevail and it is why people become so frustrated when reaching agreement causes delay.

Attitudes haven’t changed all that much since research was undertaken by legal scholar Stewart Macaulay in 1963 and subsequently updated in 2013 by Professor Gillian Hadfield. In fact, those studies even question the relevance of a contract when things go wrong: “Written contracts (are) often highly standardized documents that (are) largely confined to the drawer once drafted by the legal department and then rarely consulted to resolve disputes”.

Macaulay and Hadfield were examining the attitiudes of business executives. But behind these superficial findings, they discovered that this attitude only applied to transactions that were relatively predictable and in themselves considered ‘low risk’ – in other words, the sale and acquisition of what today we might term ‘commodities’. As soon as performance becomes less predictable – for example, because of potential changes over time, uncertainty over requirements or capabilities, potential confusion over ownership or an expectation of innovation – ‘contracting’ becomes much more significant. Those executives not only started to care more about legal implications, they especially  appreciated a need to “coordinate beliefs about what constitutes a breach of a highly ambiguous set of obligations” and to identify shared approaches and strategies that induce compliance and performance.

These concepts are of major importance because they can help us realize far more value from our trading relationships and they indicate the nature of the changes we need to make, especially in the approach to procurement.

On one level, it might be argued that procurement strategies which seek to break transactions into separate ‘commodity’ elements are really smart. They simplify acquisition and reduce the relevance of the contract, making it consistent with the use of ‘standardized documents’ that require little understanding of contract terms or behavioral economics. This turns the act of procurement into a process which often operates to avoid negotiation, not to support it.

In an era when most acquisitions were for standardized goods, there was a logic to this approach. Where it  falls down is in the acquisition of more complicated items, such as IT systems or software, where requirements and performance are harder to define. It becomes especially problematic when purchasing long-term services, which by their nature are intangible and require far greater definition and management.

Today, while commodity purchasing remains a high volume of activity, the majority of business spend has moved from goods to services. We are buying performance, outcomes and sustainable relationships. In many organizations, Procurement skills and processes simply have not kept pace. They remain focused on driving down the price of commodities when they should instead be focused on working with suppliers and supply networks “to identify shared approaches and strategies that induce compliance and performance”.  The discipline provided by contracts and the contracting process is fundamental to achieving this shift.

But the need for change goes beyond the Procurement function. It requires a new business attitude and a recognition that better performance depends upon integration across entire relationship networks. In other words, businesses need to start with an appreciation of the commitments they make to the market and they must flow those commitments (and updates to them) through the organization and into their supply agreements. Right now, there are multiple disconnects. Many functions operate as silos with limited appreciation of customers or markets. There is rarely adequate connection between those who form contracts with customers and those who are contracting with suppliers. Relatively few organizations see a need for sell-side and buy-side resources to co-locate, to use the same systems or to undergo similar training and to have complementary goals and objectives.

IACCM research consistently shows that these divisions in organizational structure cause substantial value and performance loss. There are compelling arguments to create an integrated function that supports ‘trading relationship capability’. But failing that, it would at the very least be smart to create an internal environment where those who develop and negotiate contracts – buy-side and sell-side – can speak to each other in the same language and have a common understanding of their role and methods.