“Loss aversion is the systematic mistake of segregating gains and losses — evaluating decisions in isolation rather than in the aggregate — and over-weighting losses relative to gains,” according to Maurice Schweitzer, professor of Operations & Information Management at The Wharton School of Business.
Prof. Schweitzer makes this assertion based on growing studies on the impact of behavior on decision making. This is important because behavioral analysis increasingly shows that we often do not make economically rational decisions – even when we are ‘experts’. For example, a study of top golfers has shown that they tend towards safe shots, rather than winning shots. And hence the observation that even they – as leading experts – focus on the immediate risk of doing well on a specific hole, rather than their overall tournament score.
This is highly relevant to all those in the world of contracting, because the comparison relates to our focus on individual transactions, rather than on the portfolio of contracts and relationships. By having this focus, not only do we sub-optimize business results, but we also create unintended risks.
Sub-optimization occurs because ‘playing it safe’ most or all of the time results in a predictable outcome, but one where we can rarely emerge as big-time winners. We fail to gain competitive edge because we consistently achieve par, but rarely score a birdie. Unintended risk arises because we are concentrating on the acceptability of individual deals and not the cumulative effect of many deals. The collapse of the bankign industry is a classic example; each individual sub-prime mortgage made perfect sense. Many thousands did not.
The Wharton study goes on to observe that behavior “reflects a bias towards avoiding loss” , In business people view performance in the context of a specific account, or a particular contract …. “People make mistakes when they view related decisions independently.” The study also refers to Prospect Theory, a concept in economics which was developed by psychologists Daniel Kahneman and Amos Tversky in 1979. Prospect Theory predicts that people become more risk averse when they are recording gains than when at risk of suffering a loss. Again, for those in the world of contracts and the law, this reflects our tendency to seek holes in new opportunities – which of course is frustrating for the optimists in sales and often also for executive management.
What lessons should we learn? Perhaps the key point is that we must find ways to undertake analysis and make risk judgments in a more composite fashion. We need tools that allow individual decisions to be made in the context of the overall contracts portfolio and that offer visibility to past experience across the organization. Most contracts and legal groups undertake deal analysis and review on a case by case basis that relies almost exclsuively on individual judgment. We lack data to observe volumes or patterns. Our insight to portfolio risk and opportunity is typically limited to personal or team experience. As a result, we are most likely overly conservative on individual opportunities – but may be guilty of allowing unacceptable risks to arise in the overall business portfolio. In addition, the limits of our personal experience may leave us unaware of the perfectly good opportunities that we are missing as a result of overly cautious risk assessment.
Adrian Ringrose recently called on the UK government to outsource more public services (Financial Times, October 19th 2009). Adrian chairs the Confederation of British Industry’s public sector strategy board and he believes that government should set ‘the rules of the game, the standards of acceptability’, but does not need to be in charge of service delivery. Interestingly, he cites the US military as an example of the potential scope for outsourcing.
Mr. Ringrose does imply one dependency – he admits that such relationships ‘must be properly structured’.
And it is here that we find the core of a problem. The structuring of relationships that deliver successful outcomes is proving extremely difficult. Organizations – both client and provider – appear to lack the necessary structures to handle complex, long-term relationships. Traditional management and measurement systems frequently get in the way. For example, it seems extremely hard to build consensus over the goals of a relationship; then it is hard to reconcile the differing views of risk; and of course different internal groups may have diametrically opposed views of the desirability of reaching agreement – some may be welcoming, others threatened.
The Economist recently highlighted this issue in an article that reported on insourcing and the return of ‘big business’. Oliver Williamson, this year’s winner of the Nobel prize for Economics, also recognizes the issue in his work on transaction cost. At the core is the challenge of building consensus that an external relationship is desirable, then finding a good and compatible partner, and then maintaining that partnership over time. These dependencies are not readily enabled by current organizational models and skill sets. And this is the reason why the US government – especially in defense – is reported to be wary of future ourtsourcing and considering reversal of some existing contracts.
One way that organizations often seek to safeguard their more complex and strategic relationships is by the creation of specialist internal groups – ranging from the traditional empowered ‘account team’, through to specialists in areas like outsourcing or alliances. Today we see the growth of ‘commissioning managers’ and Supplier Relationship Managers. These groups may offer special skills, but often they are also powerful and well-connected advocates charged with overcoming internal resistance. Results show this is often a thankless task.
Another approach – consistently highlighted as a key dependency in surveys – is to appoint a powerful executive sponsor, whose sustained involvement is needed if key relationships are to succeed.Yet of course executives cannot be involved on a daily basis in every important relationship and creating specialist teams is both inefficient and contentious. And that is why – if complex contracts are to succeed – the total contracting process must be overhauled and the management of complexity must become a core organizational capability. We need to understand that investments in standardization and compliance were not end points, but that they represent a firm base from which uncertainty, change and variation can be measured and managed. We must not become constrained by the standards we have created; we made that investment so that we can free resources to manage exceptions in an intelligent and standardized way.
The reason that contracting is so important (according to Professor Leslie Willcocks, it is one of the three core competencies required by any successful 21st century business) is that it has become an instrument of relationship segmentation and quality control. It is also the basis for the management of change in a controlled and harmonious way. Neither party to a contract has an innate interest in disputes, yet without the right instruments for on-going dialogue, without the right balance of risk, without the mechanisms to manage the inevitability of change, then dissatisfaction is almost inevitable.
Key to success is on-going communication. But of course not just any communication. Because these are business, not personal, relationships, communication must have structure. Much of it may be virtual, through inter-connected systems (especially with the advent of cloud computing). One thing that is certain is the need for the right skills and people with the right incentives and measurements – and the right governance tools, established and maintained through the contract.
Mr. Ringrose is absolutely right to call for more outsourcing because, in principle, it can deliver far better service at lower cost to the taxpayer. But unfortunately, when it comes to ‘proper sstructure’, we are struggling. As a result, there are some dependencies that must first be met because failed contracts cost money and damage reputations. Failure is not inevitable; but consistent success requires new thinking about the way that contracts and relationships are inter-connected and inter-dependent. And that, of course, takes us back to the core mission and agenda of IACCM …..
As The Economist points out, market segmentation is a topic of growing interest and sophistication (see Segmentation). Traditionally, it is the process by which we slice ‘markets’ into different types, in order to improve services and increase revenues. However, the technique is increasingly used more broadly by any organization or group providing products or services, in order to ensure the efficiency and relevance of their offering to customers or users.
I find the topic of segmentation fascinating because of course it has direct relevance and application in the world of contracts and relationship management. As The Economist points out, the technique was a direct reaction to the ‘one size fits all’ mentality of Henry Ford. While the Ford approach was undoubtedly efffective in delivering high volume, low cost products, it was not effective at meeting the needs of specific groups – for example, those with large families, or greater wealth.
Large corporations have tried to simplify the complexity and risks of contracting with similar ‘one size fits all’ models. Under pressure, they would agree to custom negotiations and some have developed a limited portfolio of contract types, or allow customization through pre-configured fall-back terms.
However, these methods continue to lack real sophistication. Contracts contain commitments and also set the framework for how the relationship will be managed. They contain provisions related to responsibilities, change procedures, rights and obligations. Often they ignore the value that the other party may place on these provisions – so sometimes the terms are over-engineered and sometimes under-engineered. Identical products or services may be put to very different applications within a customer organization – and therefore demand very different commitments from the supplier.
This concept of needs-based segmentation is still relatively immature and unfortunately many contracts groups – buy and sell – are relatively remote from their product and service development teams. Those products and services are therefore brought to market with ‘one size fits all’ terms and conditions, which can then be changed only through individual negotiation. Not only is this inefficient, but it creates risk. This risk is because we find ourselves making non-standard commitments that the business has not enabled – hence the cost of performance is greater and the risk of non-performance higher.
I observe some companies aligning contracts and commercial staff with the product or service lifecycle management teams and ensuring one basis of market segmentation is the understanding of different commitment requirements. Of course, this analysis may lead to certain segments being viewed as unattractive because of the implied terms and conditions. For example, risk averse customers (or suppliers) may not be selected because of the low margins they represent. Indeed, I was talking just today with the head of supply management at a major financial services company and he was observing how some of those he views as top suppliers are becoming more and more selective about when they decide to bid. And he realizes that he should view their no-bids as a warning sign that maybe his requirements are wrong.
All of us in the world of contracts – whether buyers or sellers – are dealing with markets. I believe that we ignore the principles of segmentation at our peril. It is something we should all understand and use to the fullest possible effect.
Recent reports suggest there is rapid growth in ‘cloud computing’ and all the indicators are that it will indeed become a massive business very quickly.
But as so often, we seem to be learning about many of the business implications only as problems arise during negotiations or implementations – and it is of course these business issues that drive contractual terms and considerations.
A short blog by Chris Cummings highlights some of these concerns. He rightly points out that the elements that make up the ‘cloud’ come from a variety of sources. The reliability of individual elements is likely to be varied. To the extent that inter-operability matters, it most likely will not be there. And of course, as happened in the early days of every past technology innovation, no one will accept responsibility for failures – it will always be a matter of pointing fingers elesewhere.
The compelling value proposition for cloud computing is the ability to scrap traditional equipment and facilities and to move towards a true pay-for-what-you use model. However, there will be real advantages in having someone accountable for the overall quality and reliability of service, as well as ensuring the provision is at low cost (which means drawing on the service at cost-efficient times and volumes). Hence the emergence of managed service providers / integrators. But the real question related to those service providers is the extent of the liability they will acept.
I highlighted an example of this recently in a link to a blog by Larry Walsh, ‘Penalties For Cloud Computing Breaches’. The continued interest by the US Government over standards of software assurance is also likely to impact the liability of software developers for the integrity and security of their product. However, ‘clouds’ are by their nature intangible and forever changing their shape. Threfore the question of who really has responsibility for the conenections within and between clouds and for the standards of relaibility and performance is likely to be a key battleground for contract developers and negotiators over the next few years.
And for those who wish to offer integrated services, the secrets of competitive advantage could well be locked into their contracting capabilities. For example, they need to develop superior commitment capabilities that promise their customers greater reliability and continuous innovation. And they will only be able to make those commitments if they have successfully negotiated back-to-back arrangements with the underlying application providers and if they continue to oversee and upgrade their relationships with those providers.
So New York State has now filed suit against Intel, claiming anti-competitive sales practices. This follows suits in the EU and in South Korea, both of which resulted in massive fines (currently under appeal).
Big companies always face a dilemma in assesssing the boundaries of sales and commercial policy. Terms that can be popular with customers may not be approved by competition authorities. Many of these cases relate to discounting policies – and especially in areas like rebates (outlawed by the EU some 20 yeaars ago, but still potentially allowable in the US).
“Rather than compete fairly, Intel used bribery and coercion to maintain a stranglehold on the market,” according to New York Attorney General Andrew Cuomo. It is alleged that rebates amounted to as much as $2bn a year for major manufacturers and depended on their loyalty to Intel. If true, such sums would obviously act as a major incentive for Procurement to ensure that orders were not placed with competitors. In case this approach was not sufficient, it is claimed that Intel threatened to end joint development with customers who strayed.
Traditional Procurement measurements often play into the hands of companies that seek to stifle competition. If ‘savings’ are the main goal for Procurement, then large rebates, hefty discounts and ‘loyalty bonuses’ are very attractive. Once achieved, it becomes very difficult to switch to a competitor since they are unlikely to be able to match these terms. The fact that competition is being stifled or that innovation is being lost is not immediately evident – and when it becomes so, it is often too late.
Such tactics are only effective in situations where a supplier has relative dominance in the market. For the competition authorities, the concern is that commercial policies of this sort stifle competition, leading over time to less innovation and higher prices. The case indicates that US authorities are perhaps becoming more vigilant in their oversight of anti-trust rules – and therefore represent a warning to many large corporations as they assess their terms and conditions.
AS AN ADDENDUM to this article, it has been announced (November 12th) that Intel has agreed an out-of-court settlement with its major rival, AMD, resulting in a payment of $1.25bn. In addition, Intel has committed to a set of ‘revised business practices’, on which I will comment once they become public.
At today’s IACCM member meeting in London, more than 100 delegates heard from IACCM Chairman Tim Cowen about current initiatives on public sector contracting.
Since leaving his role as General Counsel at BT Global Services, Tim has been leading a multi-company effort to address some of the challenges in EU and UK government contracting practices. He explained how past work had demonstrated that government was often ‘shooting itself in the foot’ when it procured major IT or outsourcing services. With the emergence of Cloud computing, there is an opportunity to re-think and learn from past mistakes – or to make them all over again.
Tim described the enormous benefits that could flow from Cloud, with the opportunity to replace or sell heritage equipment and facilities. Estimates of the achievable savings to the public purse vary enormously, but conservative views suggest a minimum of £44bn. over 10 years for UK central government alone.
But many past acquisitions by government have not been successful. In some cases, they have simply failed to deliver any tangible benefits; in others, they tend to overshoot on cost and / or delivery schedules. Research has shown that much of the problem is driven by risk averse attitides and terms, which attempt to place the burden on the supplier. This approach destroys trust and inhibits openness and cooperation.
The work of the Open Computing Alliance (OCA) is promoting focus on governance through contracts. It proposes that both sides must have incentives to perform, including the allocation of appropriate resources and skills to ensure on-going project and relationship management. Tim highlighted how – despite years of evidence to show the negative impact of risk transfer – these tendencies still prevail. He highlighted the recent inclusion of ‘time of the essence’ clauses in many high-risk projects. Such terms enable arbitrary action by the buyer and discourage open discussion or mutual attention to risk.
Tim also expressed the need for greater integration and consistency across government departments. For example, benefits would flow from a consistent financial system that used common accounting standards.
The key lesson from studying years of public sector contracting for complex technology and outsourced services is that contracts which impose burdens on the supplier that do not reflect the intent or structure of the relationship will cause problems. Relationships matter. They must be supported and managed through appropriate terms and conditions that set out balanced and complementary responsibilities for performance.
I am looking forward to talking soon with Professor Guhan Subramanian, Joseph Flom Professor of Law and Business and H. Douglas Weaver Professor of Business Law, at Harvard Business School.
Professor Subranamian has been writing about what he terms ‘negotiauctions’ and the challenges of dealing with ever more complex deal-making. He perceives the business world increasingly integrating traditional negotiations with auctions in order to achieve greater value.
His ideas are certainly interesting. As previously reported in this blog and elsewhere, the indiscriminate use of auctions can be extremely damaging to key relationships and business outcomes. Yet traditional negotiation is often inefficient and tends to be more subject to personal relationships and influences. Professor Subranamian is not unaware of the difficulties that face businesses in establishing successful deals. He highlights that it is not simply a matter of agreement between buyer and supplier, but each is also undertaking internal negotiations at the same time.
This challenge of ‘doing the right thing’ came up again today, when I met with two fomer General Counsels, one from banking and the other from technology and outsourcing. Each of them was reflecting on the difficulty of overcoming organizational metrics, especially in long-term deals where value is not achieved at the point of signature. They discussed how Sales motivation systems and Procurement measurements still hamper the creation of longer-term value and tend to drive to less efficient and more acrimonious relationships.
So I have a lot of questions in store for the Professor and I am sure many IACCM members will look forward to hearing him on a future Ask The Expert call, when they too can seek answers on the ways that Negotiauctions may help us do better deals.
Another of the topics discussed at the recent IACCM meeting in Boston was the growing use of Codes of Conduct or Codes of Practice by many corporations.
Despite recent rejection by a US court of complaints brought against Walmart for a claimed breach of its Code, there is still uncertainty over how courts may view such actions in the future. But regardless of the legal implications, we must assume that executives introduce such codes because they are considered important. In most cases, they tend to address key reputational issues that could adversely affect brand image and value.
Richard Cellini, of Integrity Interactive, highlighted the challenges in overseeing such Codes. “Management needs help with issues around ethics and compliance – staying out of trouble”, he observed, citing a range of examples including Siemens, BAE, Mattel, Pfizer and the many other complaints and fines over issues such as data privacy. “In the end, these incidents have far more visible impact than topics like liabilities, indemnities and choice of law.”
The discussion centered around the role of contracts and sourcing staff in overseeing and managing the implications and actions associated with Codes of Conduct and corporate social responsibility. “These initiatives are viewed by many as ‘off-contract'”, commented one, “And that means they are not seen as relevant or part of the job role.” But in the end, these ‘promises’ are also commitments and breaches clearly represent risk – both areas which are without doubt considered within the general job role and competence of contracts staff.
There was also discussion of the complexity in overseeing such Codes, especially in a multi-national / multi-cultural environment. With regulation increasing – for example in areas like product origins and employee work status – there is growing need to consider where responsibilities for compliance should lie and the extent to which these need to be reflected in contracts. Today, term and condition implications are often ignored, or alternatively are poorly enforced.
“Regulated industries are often the worst”, said Richard. “Having invested in large compliance functions, management often deludes itself that they have achieved control. But without the right interfaces and tools to manage their trading relationships, this control is simply a mirage.”
In the US, those leading the administration’s contract reform initiatives have apparently condemned ‘relationships’ because these are seen as too ‘cozy’. Certainly, recent criticisms of defense procurement (with suggestions of tie-ins between major contracts and campaign funding) are just the latest in a series of events that rightly lead to concerns about the closeness of relationships between key decision-makers and promote a need for improved oversight.
Yet at the same time, we have IACCM members on both the buy-side and sell-side complaining about the weakness of relationships and how this prevents the delivery of value. For example, in last week’s webcast on The State of The Global Economy, one senior Procurement representative bemoaned the problems they have in re-opening negotiations on contracts affected by the recession. “We don’t want to simply push down prices or extend payment terms”, she commented. “We want to have a full discussion on how we can work with our suppliers to rebalance value. But it seems impossible to get most of them to engage.”
I think there is a common problem that underlies these two very different issues. It is not that we lack relationships – but rather that we lack the right relationships, because we tend to see them predominantly in terms of people rather than organizations.
When I ran large business functions, or led organizational change, I was frequently frustrated by the insistence of business units that they must have dedicated and named individuals to provide services. The fact that this drove inefficiency, higher cost and frequently resulted in less skilled service provision seemed to count for nothing. There was a belief that a dedicated interface (ideally physically located with ther teams) would result in better understanding of needs and more commitment to delivery.
This same mentality often pervades the use of the Sales function and its interface to customers. When acting as a coordinator of needs and resources, there is great logic to dedicated Sales resource (though the frequency with which sales personnel are rotated often begs questions over how much they really understand the customer). However, there are many in Sales who tend to keep the organizations at arm’s length – they protect their position and perceived value by limiting direct contact.
And regardless of whether or not individual sales representatives have the right motivation, the truth is that organizations are not good at building relationships at a business level. For example, most contracts define a range of interfaces and contact points for notices, for change management etc. Yet work by groups like Integrity Interactive has shown that in a majority of cases, these are out of date – addresses, phone numbers, e-mails are simply wrong.
So the real challenge, in my opinion, is for us to move beyond relationships that depend on individual executives and sales representatives (and are thereefore unduly subject to behind the scenes and ‘cozy’ agreements) and to move everything into the spotlight of proper interfaces and governance. There are many options on how this can be achieved (groups like Integrity Interactive are specialists). It also demands a wider range of interfaces – for example, between contract managers in the respective companies – so that when the world changes they can rapidly and intelligently discuss how to adjust the existing agreements, as well as providing the ‘independent oversight’ that legislators increasingly view as fundamental to improved corporate goverance.
With modern technologies, we really do not face the stark choice of cozy and unethical versus arm’s length and adversarial. What we should be doing is ensuring personal relationships are balanced by robust and sustained organizational relationships. And embedding these principles into our contracting would be a great place to start.
What exactly is the future of Procurement?
I believe this to be one of the big questions right now. For years we have heard that Procurement is becoming ‘strategic’ and that CPOs are ‘at the top table’. Yet the very fact that this is still so often stated reveals how far it is from the truth. In most companies, Procurement remains highly tactical and its role is largely about achieving low cost, reliable sources of supply. Its performance metrics reflect this.
These are important tasks – and arguably have become more so with the advent of outsourcing and the move towards solutions and services. But it is precisely these trends that raise fundamental questions over the role of Procurement. Acquiring and managing solutions and services requires very different approaches from the acquisition of products and supplies, and traditional Procurement functions are largely struggling to adapt.
It is becoming steadily more clear that concepts such as commoditization frequently damage business results. It is also the case that modern technologies can replace traditional purchasing roles and empower business units to undertake many tasks without the need for dedicated ‘professionals’. Yet many groups seem trapped in these activities and unable to break into the higher value areas that demand focused attention.
The areas that are strategic and have become critical relate to more complex make / buy decisions based on analysis of costs over time (e.g. insource versus outsource; offshore versus nearshore etc); more sophisticated negotiation and risk management techniques; and on-going contract and relationship management, including especially the management of change.
These are areas in which many Procurement groups are struggling to gain traction. In some cases it is a failure of leadership, or because of an absence of necessary skills, and in others it is simply that executives do not trust Procurement to do the job or do not want to risk diverting them from traditional cost-cutting. As a result, there is often fragmentation of roles – for example, specialist groups spring up to handle IT contracting, or outsourcing, or sub-contracts; others are developed to handle post-award contract management and Supplier Relationship Management. While some of these specialists come from the ranks of traditional procurement, many do not. And frequently there seems to be a real lack of cooperation and respect between these groups – indeed, they behave as rivals.
The overall picture is therefore one of real uncertainty. Threatened by technology in the performance of its traditional role and threatened by new, specialist groups in the roles of the future, is Procurement in fact in danger of being squeezed into steady and continuing decline?
Commitment Matters 