In the lead-up to the Contracting Excellence Summit in Australia, I was asked to comment on a paper that suggested we must have ‘absolute certainty that contract selection is ‘best for project’.
I agree that a contract must be ‘fit for purpose’, but of course this also means that organizational capabilities within both buyer and seller must match the commitments and obligations contained in that ‘best for project’ contract.
There is no question that the role of the contract is becoming more important in business to business relationships and major projects. There are numerous factors behind this, but among the most significant are the impacts of globalisation (many relationships cross borders, languages and are quite simply more remote); economic volatility; technology innovation; and the speed of change. Overall, these combine to create increased levels of risk and increased probability of misalignment between the contracting parties.
As a result, the role of the contract is shifting from being primarily an instrument for risk allocation, to becoming an instrument for relationship governance, communication and performance management – including, of course, managing the dynamics of change.
So the hypothesis of the paper is correct in highlighting the importance of ensuring that the contract structure and terms are ‘fit for purpose’ relative to the specific project or sub-project. Indeed, as we look at the causes for project failures or overruns, it is increasingly clear that these are rarely due to technical problems, but primarily to commercial or relationship issues.
There are a number of key principles which the contract owner should ensure are followed, because these appear to be among the most frequent causes of poor performance.
- Don’t expect the supplier to subsidise or suffer from your inefficiencies. Reducing cost is important to all businesses. But the up-front price negotiation is only one source of reduction. The costs and risks for both are substantially affected by the efficiency of the contract owner and their application of resources and procedures that are focused on outcome delivery. Without these, not only are true costs increased for both parties, but the supplier must build a buffer into their price to allow for this expense (or will engage in post-award pricing actions to protect margin).
- Change is inevitable and increasingly frequent. Having the right change provisions in the contract is important. But it is also essential to have the systems in place to manage and negotiate change. The old game of suppliers trying to charge for everything and the customer claiming that everything is in scope are unproductive and must be addressed if the outcome is to be successful.
- Contracts must be considered in the context of relationships. A relationship may offer leverage which an individual contract lacks, yet in many projects, it is forgotten that there may in fact be a much wider context to resolve issues and problems. This interconnection should be a key aspect of supplier selection and contracting strategy.
- Agility is about more than flexibility. Often these two characteristics are confused – and it si common for the contract owner to see them as a supplier responsibility. Agility is key to managing performance – by both parties. It is about both speed and flexibility, a readiness to review and reengineer the contract as needed by shifting conditions or needs. It must be mutual or it will not happen.
- Ambiguity and uncertainty are sometimes unavoidable. Many contract specialists rightly complain that requirements are often vague or imprecise. They are right – and this is a common source of dispute. However, the answer is not to demand greater precision as a pre-condition to contract. There are times when the contract must be designed around the uncertainty – and that calls for a different structure, appropriate milestones and perhaps phased releases of budget.
- Improve analysis and learn from experience. Discrete projects rarely lend themselves to collective learning – and that is a bad mistake and results in regular repetition of the same problems. As a simple example, the causes of claim and dispute remain remarkably similar across a portfolio of projects. If we really care about risk reduction, we must consolidate information and take remedial steps. And the top causes of claims and disputes are virtually all connected with commercial and contracting issues.
It was about two weeks before final exams in High School. I recall my mother looking increasingly concerned, until one day she said:”Don’t you think it is time you started to revise?” My reply was: “It’s too early. I have to wait until I get a sense of urgency.”
I often think of that conversation (perhaps because my mother loved to tell the story) whenever there is discussion about the importance of planning. What effect did my last-minute approach have on the results I achieved? In my mind, I justified delay on the fact that if I started to revise early, I would have forgotten most things by the day of the exam. I needed time pressure to raise my performance and stimulate my mind.
In business, there is a regular call for improved planning. This is especially true in the field of negotiations, where consultants and trainers frequently emphasize the impact of poor planning on the results achieved. We automatically tend to associate this with a need to engage earlier and spend extensive time practicing, revising and preparing for ‘the big day’.
Despite these calls for more planning, nothing much seems to change. In most cases, that is because they fly in the face of business realities. Until the day is imminent, there just isn’t the required ‘sense of urgency’ to engage people’s minds. And of course, ‘good plnning’ does not necessarily mean lots of it, nor that it has to start way in advance. In fact, with the volatility of today’s markets, it may well be desirable to wait for the last moment and ensure the plans reflect current conditions.
So in this context, ‘good planning’ may mean developing a streamlined process that supports a ‘just in time’ approach to negotiation.
Last week IACCM ran an interview with Michael Held, a partner at Deloitte Consulting who had led research on the supply impacts of the Japanese tsunami.
In our conversation, we agreed that an increase in unexpected events is an inevitable consequence of extended supply chains – and therefore, by definition, of low-cost sourcing. Michael set out a thoughtful response to this when he introduced a concept called Risk Adjusted Pricing (RAP), which factors relative risk of supply chain disruption into price comparisons. He illustrated how this could be used to determine a truer sense of competitive cost comparisons and therefore lead to improved buying decisions.
One listener commented: “From the example given in the seminar, the in-country vendor is $11 (approx) more than the Chinese vendor. Assuming the pricing to be FOB Destination (apples to apples comparison), the bottom-line here is that I am out $11 hard cash if I choose the in-country source. Even though the RAP for China is $13 (approx) more. That’s theoretical cash (funny money).
I go with China, I save $11 that goes to support my bonus goal and to my firm’s bottom line.
I go with in-country – I have a tough time coming up with $13 theoretical dollars to apply to my bonus goal and to my firm’s bottom line.
Short sighted, yes, but I think it’s more of a reality for most businesses. It’s easier to blame a force majeure than spend more while your competitor is lucking out with the riskier supplier.”
The truth is that Procurement would prefer to have both a low price and low risk. But the weighting right now is strongly towards the former, at the expense of the latter. And in general, there is no tool or method to establish the value of paying a premium to reduce risks that are often unquantifiable for a single supplier or transaction.
The story may be a little different in a highly regulated industry such as aerospace and defense and this may indicate a re-balancing in other industries where regulatory pressure is increasing – for example, oil and gas, financial services. The cost of actual and reputational damages has to be sufficient to overcome the hunger for front-end savings.
And what about the role of the supplier in all of this? If someone wants to sell at premium prices because they offer superior management of risk, there are two important implications:
- terms and conditions must be adjusted to reflect that readiness to absorb customer risk (an implication that they will be recompensed if it occurs);
- data must be available to show the return on investment (ROI) that will typically be achieved from paying that higher price.
Contracts professionals and lawyers have grasped the concept of agility and flexibility. They all embrace the fact that we need more of it (though mostly from the other side!) But in reality we are stuck in traditional thinking.
We asked IACCM members whether flexibility and greater agility in contracting are important. Almost 90% said yes and that their management is seeking better answers to traditional contracting issues. So what do we then focus on? This Wordle chart is a great representation of the current areas of contention in negotiation and reveals the focus of our thinking. This illustrates why we are stuck having the same unproductive discussions. Unless we break free of considering flexibility only in the traditional areas of contention, we will make no progress.
Tomorrow I will suggest how we might change the conversation – and please share your ideas and experiences.
The wrong contracts and contracting strategies can undermine innovation.
As businesses look more and more to their trading partners as a source of innovation, it is important that we understand how best to encourage the collaboration needed for innovation to flourish. Trust is fundamental, as are the right relationships and forums for discussion and review. You cannot contract for innovation; but you can certainly create a healthy environment through terms and conditions. Or alternatively, you can generate negative behaviors that will defeat efforts to innovate.
At the IACCM Global Forum for Contract and Commercial Excellence, delegates will gain insights to the forms of contract and commercial policies that establish innovative relationships. And of course, in today’s service and solutions based world, the contract terms themselves can be a source of innovation and differentiation as well. For now, here are ten tips to get you started:
| Develop and pursue relationships on collaborative principles and fair allocations of risk |
| Build open, bilateral communication strategies and escalation procedures |
| Create trust and shared responsibility as a foundation for contracting and relationships |
| Foster a “no idea is useless” mentality and ensure the right forums for review of ideas |
| Understand who will own the innovation and how the parties can use it in other relationships |
| Understand the other party – the people, the enterprise – and ensure a cultural fit |
| Build recognition and reward as an integral element of the program |
| Do not discount and prevent ideas that were not viable in prior contracting situations |
| Mitigate fear without encouraging carelessness |
| Recruit and anoint “innovation champions” in both contracting party organizations |
In late October, IACCM will hold its Global Forum for Contacts & Commercial Excellence. I typically write a briefing for speakers, to ensure consistency in the theme of the event. This time, I focused on a number of the key principles that we have been promoting to our members over recent years, to assist organizations to reach ‘best practice’ standards in their contract and commercial capabilities and practices.
I thought that readers of this blog might find this summary of interest – and may wish to add their comments:
What do we mean by contracting?
First, we see contracts as instruments of economic value, in which legal considerations are of fundamental importance, but not their primary purpose. Contracts represent an economic arrangement and should be designed to maximize the probability of a successful outcome.
Second, we see contracting as a life-cycle activity. Businesses must have a contracting strategy (contracts, terms, policies and practices that support the goals and needs of the organization). These are then applied and adjusted during the opportunity or needs evaluation, negotiation and post-award environments. Contracting brings cohesion across these phases of activity and provides a framework for clarity over requirements and goals, roles and responsibilities and on-going relationship governance.
Third, because of this scope, contracting has many stakeholders. Legal, Finance, Operations, Project Management, Sales, Procurement – each has areas of policy or resource interests which make them sensitive to changes. Recent research by IACCM concluded that ‘many negotiations are driven to protect functional positions, sometimes at the expense of business interests’. Good contracting ensures reconciliation of these conflicts and results in creative (as opposed to destructive) contention.
There is soaring interest in contracting.
We believe that contracting is one of ‘the next big things’ in the world of business. That is because the wider view of contracting outlined above is a critical contributor to the management of complexity. Economic conditions are pushing organizations towards new sources of savings; into new and emerging markets; to dealing with unfamiliar cultures and business practices; the growth of Asia is shifting the power of businesses to impose their way of working; companies are dealing with increasingly complex interdependent systems. CEOs are struggling with how to understand, make sense of, and manage ‘interconnections and interdependencies’. The analytical and disciplined approaches that contracting brings are fundamental to supporting this, plus they then provide a firm platform for the management of change (which today is inevitable during the lifetime of every relationship).
Contracting contributes to the organization’s agenda.
In today’s environment, business must become better at managing risk. This is not about risk allocation. It is about building contracts and relationships that are better at reducing the probability of risks occurring, or of managing them to a successful conclusion so that contract outcomes are achieved. Business must become better at eliminating bureaucracy and unnecessary rules. Those in Legal, Procurement and Contract Management have extensive visibility into many of those rules because they are managed through contracts. So instead of protecting and sustaining them, they must increasingly challenge and change. Business must become better at forming and managing relationships. Being a customer or supplier of choice, innovating through collaboration, combining resources to tackle major risks and opportunities, will be key to survival and growth. Bad contracting – unfair or unbalanced terms – will undermine those capabilities and result in adversarial or defensive relationships. Contracts must provide a framework for harmonious relationships that are dedicated to mutual success.
The IACCM conference will illustrate these core values and inspire delegates to return to their organizations as purveyors of ‘best practice’ and as ambassadors of change. These, after all, are the fundamental attributes that underpin the entire concept of being ‘a professional’.
Many companies are reviewing or increasingly engaged in business in emerging markets. For some, the driver remains a need to find lower cost sources of supply. But for many, it is because established markets do not offer the scale of opportunities needed to support business growth. Overall market and economic conditions are forcing increased engagement with new and unfamiliar markets, for business development and sales.
New market entry and new customer or supplier adoption always entail uncertainty and risk. Some organizations have great experience and a replicable assessment and ‘on-boarding process’ to gather necessary information and manage these risks. But many do not. They are driven by either the need for speed, or overall lack of discipline, to undertake high-risk projects and to learn as they go.
There are growing resources to assist companies on their journey to the unknown. IACCM has data in its learning programs and undertakes periodic research, such as its 2010 study of the major risks within the top 50 trading nations. But a resource that I strongly recommend is the Supply Chain Risk blog run by Jan Husdal (see www.husdal.com). It offers the most thorough and thoughtful analysis of risk topics that I have ever encountered, drawing on and referencing many of the major works in this field.
Although Jan’s work is in some ways more related to procurement and logistics, there is much here for those in sales contracting or commercial management. His recent paper on emerging markets is a good example and I commend it as a place to get started.
The IACCM executive forum is designed for leaders or aspiring leaders. A book by Robert Kaplan, Professor of Management Practice at Harvard, may offer some useful insights into the characteristics and requirements for leadership. For example, this comes from a recent interview with Prof. Kaplan:
“You must ask “What is your vision for the business that you run?” A lot of the time, people can tell me, and a lot of times they can’t. Why? Articulating a vision is based on what your distinctive competencies are. As the world is always changing, many people have to think about that. They’re not sure. I try to stop people and ask: What are your distinctive competencies? What’s your aspiration? And then I ask: what are the 3-5 things you must do superbly well to achieve that vision? This is a very simple conversation, but often when a leader is having a problem, invariably they are not clear themselves and priorities, or they are clear but don’t communicate it enough to their people. It’s very hard to be a good coach if you’re not clear with your direct reports and subordinates, as well as lateral relationships. How can you coach them if you don’t really know what you what and where you’re going? Everything you do needs to align around that vision.”
I think this statement offers a useful context for the forum (and our subsequent report). We are working to provide a vision, so that the leaders for contracting and commercial management can give thought to their priority goals and assess the competencies their organization must have or devlop to meet the vision and goals. And from there, they have something clear to communicate.
Our research shows that many professionals in our field do not have clarity over their future, over what they must achieve, over how they will contribute – and that leaves them frustrated. But if they don’t know the answer, imagine how people elsewhere in the business must feel – obviously they see associate a function with an unclear purpose as lacking real value. And certainly they do not associate it with leadership.
Commitment Matters 