IACCM recently hosted a roundtable discussion to explore industry attitudes towards contracts based on ‘payment by results’.
As buyers shift from seeking low price to value for money, it is inevitable that suppliers will be expected to commit more firmly to performance. This typically extends the period of engagement for the supplier and leads to the question “When should I be paid?” Many buyers – business and consumer – will increasingly expect that value is visible prior to payment, in whole or in part.
For Governments, ideas like payment by results have particular attraction. They see it not only as a way of encouraging supplier honesty and performance, but also of demonstrating responsible handling of public funds. Therefore the results of this roundtable discussion are being shared with the UK’s National Audit Office as it explores developing guidance on ‘payment by result’ contracts.
There are problems with this approach – some practical, others reflecting attitudes. For example, will such an approach simply lead to higher prices because of the perceived additional risks? Will it result in major suppliers deciding not to bid? Is payment by results compatible with other Government policies, such as expanding business awarded to small and medium enterprises? With regard to attitudes, there was a degree of cynicism at the table that this was just another way for the public sector to avoid its responsibilities in driving good performance. The point was made that many contracts are risky because the customer doesn’t really know what they want, or there is political interference, or the client lacks skills at performance management. In these circumstances, payment by results will not fix the problems.
One participant made the observation that buyers must understand the overall supply chain before moving in this direction. It is not only a question of whether the contracted supplier is willing to work on this basis, but also whether they can impose similar terms onto their suppliers. In many industries, the market lacks real competitiveness and tier one suppliers may simply refuse to do business in this way.
A wide-ranging discussion resulted in many ideas and insights, which are being turned into a summary paper. Please add your comments or experiences. This is a subject that shows every sign of growing in importance.
Contracts are written to reflect a wide variety of business policies and practices, as well as product or service capabilities. At a time of rapid change, it is inevitable that terms need continuous review and update.
Examples of change come in the form of regulation – for example, the European Union and payment terms, the US and revised revenue recognition, China and software code. It may be driven by market volatility – for example $50 oil, turmoil in the Middle East, the emergence of the AIIB – or the challenges created by growing social transparency and reducing trust – for example, the recent initiatives by Microsoft and Amazon regarding labor practices, or the more general trend towards supplier responsibility for outcomes.
Existing contract models are often not appropriate; traditional templates and terms are too rigid; perceptions and evaluations of risk are too narrow. Contracting processes are struggling to catch up with the trends towards empowerment and self-help. These factors cause contracts to be viewed as inhibitors to getting business done. For many organizations, this results either in lengthening cycle times for negotiation and drafting (as demonstrated by IACCM’s recent benchmark study) or in contracts that are simply not suited to the purpose for which they are used.
Overall, this means that the incidence of financial loss from poor contracting is increasing.
Driving improvement is difficult because in most organizations there is no clear owner of the contracting process. In those organizations where leadership does exist, several areas of improvement are starting to emerge:
– shifting appreciation of risk, focusing more on analyzing the likelihood of risks occurring
– greater use of relational and performance based contracts (which IACCM research suggests cut failure rates by up to 50%)
– growing sophistication in the use of agile contracting models, with work to reconcile budgeting and forecasting systems
– user-based contract models and tools, to ensure fast and accurate dissemination to those who are responsible for implementation and performance
– analysis of contracts for business intelligence – in particular insight gathered from across the contract portfolio, not just individual transactions
For those leading these changes, contracts do indeed become a business enabler and a source of competitive difference. They reflect businesses that are adept at change – and therefore far more reliable trading partners.
“We have a mix of customers, some on contract and some without contracts. I analyzed customer satisfaction results – and found those with contracts are almost twice as happy as those without. The contracting process results in clear expectations and more disciplined performance.”
This insight came during a discussion at an IACCM member meeting in the UK – and it was from a representative who works in a major international corporation. Once again, it reinforces the observation made in one of my recent blogs – “contracts are a framework for business operations”.
That automatically points to the role that contracts play in driving business efficiency. But the latest IACCM benchmark data reveals that it isn’t just the contract that matters – it is also having a structured contract management organization. Companies that operate with a full-time contracts or commercial organization use approximately 35% less resources than those where contract management is performed in a devolved fashion, or as an element of other jobs.
The IACCM study gathered input on where and how the contract management role is performed. As part of the data, it explored the number of FTEs used to perform contract management tasks. In many organizations, there are dedicated practitioners, plus others (for example in Sales, Project Management, Procurement or Legal) for whom it is part of their role. What we discovered is that the overall number of FTEs required to operate in a devolved organization or where contract management is just a component of a job is substantially greater than the number needed when there is a consolidated contract management function. On average, this represents around 40 heads, but in large corporations (over $40bn annual revenue) this can increase to several hundred FTEs.
51% of contract managers say that payment terms have become a more contentious issue in their negotiations, with many smaller companies under pressure to accept longer payment periods. Overall, 70% of companies say that they have adjusted their standard payment terms during the last 2 years.
In a recent IACCM survey, 18% of major corporations (those with over $40bn annual revenue) acknowledge that they now pay suppliers on 90 day (or more) terms. This compares with just 5% of smaller companies (revenue up to $10bn). Larger corporations are also more likely to impose ‘early payment discounts’.
40% of smaller companies report that more onerous payment terms are being imposed on them by their customers. This compares with just 22% of large corporations facing the same pressure. There is universal agreement that the main factor determining acceptance of these provisions is negotiating power (59%), followed by ‘the nature of the relationship’ (43%). Just 25% say that they vary terms based on geography or market segment – pointing to the trend towards universal consistency.
However, important regional variations remain in place. For example, in the US, the trigger for invoicing often remains ‘shipment’ – a concept rarely used elsewhere. In the Middle East, Africa and Asia, there is a greater tendency to invoice on acceptance and for the payment period to commence on receipt of invoice – but these more generous terms are accompanied by 30 days remaining the norm for the payment period.
Smaller companies also experience greater difficulty in getting paid. 77% say that customers typically adhere to the payment terms, whereas this rises to 92% for large corporations.
The survey also revealed that European companies are the most likely to use outsourced payment centers, with 20% making use of such services, versus 15% in the United States and just 9% in Asia.
The reasons for extensive negotiation immediately become apparent when comparing the standard positions of buyers versus sellers. For example, 67% of suppliers still attempt to operate on 30 day terms. Just 16% of suppliers include early payment discount in their contracts, whereas 40% of customers seek such discounts. When it comes to charges for late payment, the position is of course reversed – with 60% of suppliers seeking such terms and 29% of buyers accepting them.
Many of those surveyed do not expect any reduction in the pressure on payment term negotiations. They anticipate that businesses will continue to see extended payment as a mechanism to enhance cash flow; they also anticipate increased levels of factoring / supply chain finance; more discounts for early payment; and continuing standardization across business units.
The IACCM survey was conducted in March/April 2015 and gathered input from almost 600 corporations. Full results will be issued by the end of April.
Last week, one of my blogs included observations on the way that attitudes to contracts are changing. In response, drafting guru Ken Adams challenged my suggestion that these shifting attitudes will lead to fundamental changes in contract design. I think his implication is that change, to the extent it happens, will not significantly impact contract structure, but will simply move from undisciplined pedantry to an alternative and more rigid style of authoring, based on his style guides.
The challenge is valid. Legal form is long established and the profession is slow to change, especially in areas where the resulting benefits are uncertain. So on what basis do I believe that change will occur?
There are a number of dynamic forces:
- Social pressure – people are demanding greater clarity. Indeed, even the CEO community now believes that a reputation for honesty and integrity is fundamental to business success and this is affecting approaches to terms and conditions..
- Generational pressure – new approaches to communication, intolerance of complexity New technologies and media have resulted in the expectation that communication is clear and honest.
- Technology – analytics are demonstrating the relative importance of different risks and the consequences of those risks. High among them: inefficiency and ineffectiveness of ‘traditional’ contracts which then damage financial performance.
- Pressure on lawyers to perform – as with medicine, there is an increasing focus on prevention – from contracts as a source of risk to contracts that manage risk.
So those are among the forces. Where is the evidence that this is actually leading to change? Here are some examples. Law schools, even law firms, are now actively working on new approaches to contracts based on artificial intelligence and the need for machine readable data. General Counsels are wanting to know the precise link between contract terms and economic impacts. Cross-industry groups are working to establish industry standards and to escape the inefficiencies and delays created by the ‘battle of the forms’. In-house legal groups increasingly appreciate their role is to enable the business, not to sit in judgment on it. There is growing acknowledgement that recourse to the courts is no longer relevant for many forms of agreement and therefore strict ‘legalese’ is unnecessary. Then there is the fact that other complex documents – such as engineering drawings – are moving into the virtual world and in the process discovering that such a move saves time and money. Finally, law schools are starting to include practical programs about contracts and contract management, preparing future lawyers to work in business, not in the courts.
Ultimately, change is most often driven by economics. And the economic case for new approaches to contracting is becoming more evident and is compelling. I understand that from where Ken sits, the pressures – and reactions to them – may be less visible. Ultimately, even something as traditional and formalized as contracts cannot stand in the way of progress.
“We must think about contracts as the foundation for business operations”, observed Steve Harmon, Deputy General Counsel at Cisco. “We’ve reached the end for strategic ambiguity in contracts – there is a need for far more clarity”.
Steve, along with Paul Lippe, CEO of LegalonRamp, was a presenter on a recent IACCM webinar exploring the implications of the new ASC606 revenue recognition standard, due to be implemented in the US (a recording is available in the IACCM member library).
The standard is significant in that it is just one more step forcing organizations to have clarity and precision in their contracts, enabling unambiguous data extraction and management. The regulation forces organizations to unbundle their contract obligations and take revenue only as each obligation is fulfilled. That means contracts staff must be far more aware of the various cost elements within a contract and to ensure there is not only clarity within the terms, but that relevant commitments and obligations are then flowed into the business and actively monitored.
This requirement simply reinforces the existing pressures for better designed contracts and for robust processes supporting data extraction, dissemination and monitoring. It plays to existing trends – such as offshore centers to undertake extraction, more sophisticated contract management systems, growing focus on the role of ‘contract owners’. As Steve Harmon also observed when talking about CLM applications: “We need to publish the implications of contract terms, not just simplify their creation”.
In summary, we are looking at contracts and their management becoming a core capability for businesses, rather than a peripheral area of administration. Contracts have been obscure, yet now they must be increasingly transparent and designed for active use. These are challenging changes for all the professionals traditionally involved in their creation and management. The pervasive nature of contract terms means that many people in the business are affected. Indeed, just yesterday I was writing an article for a Sales journal, explaining the impacts on the traditional sales and account management teams.
Over the next two years, we will see a fundamental reappraisal of contract design and wording, challenging the way that traditional legal drafting has occurred. We will see fundamental changes in the software to support contract management, as artificial intelligence and machine readable data facilitate extraction and dissemination of information. We will see fundamental changes in the way that contract portfolio performance is monitored and business intelligence is generated to drive marketing and policy decisions, as well as far greater sophistication in understanding and managing risk. And this means we will without doubt see fundamental changes in the way that contract management skills are developed and deployed.
‘Just because you can doesn’t mean you should’ …. That is a principle which every organization should apply when developing its terms and conditions and underlying business policies.
It certainly seems to be the case in the recent announcement by Amazon that it will no longer require contract staff to sign non-compete agreements (at least in the UK). Many of these workers are on minimum wage and on variable hours. The inequity of such a term should surely have struck any fair-minded executive at Amazon and resulted in such a provision never being imposed. But it did not – and this calls into question the internal review process for policies and contract provisions.
According to a recent study of European CEOs, ‘honesty and integrity’ are today’s most important attributes for business. They may well be right, since public and political opinion is increasingly hostile to what is seen as unfair and manipulative behavior by many large corporations. Examples abound – for instance on issues such as payment terms, rights of termination and ownership of intellectual property. Amazon is certainly not alone in using its power to impose one-sided contracts.
It sometimes seems as though companies take the view that if there isn’t a regulation prohibiting it, any action is acceptable. But of course it is not – and this points to a key failing in many organizations today: a lack of judgment.
This issue of judgment is not new, but it is increasingly complex. Our interconnected world, the growth of specialism, the shift in public and political expectations have combined to multiply the range of stakeholder views that must be taken into account. At the same time, functional silos within business have made it increasingly difficult to reach balanced decisions on a timely basis.
It is this set of dynamics – and the need to project ‘honesty and integrity’ – that underpins growing interest in ‘commercial acumen’. Organizations need their staff to have greater awareness and sensitivity to the potential consequences of their actions. Those who prepare or draft such terms must, in particular, be a last line of defense and ready to challenge the wisdom of the policy sponsor. For those in procurement, contract management or legal, the opportunity is clear: it is time to have the courage to demonstrate capacity for judgment.
So Microsoft now requires its suppliers to commit that their workers in the US receive a guarantee of paid leave. This requirement will apply to all employees who do ‘substantial work’ for Microsoft.
This announcement has a number of fascinating implications – and reinforces my past blogs suggesting that the contract and commercial management community need to start taking sustainability issues far more seriously.
First, I was interested to note that it was Microsoft’s General Counsel, Brad Smith, who made this announcement. It’s not the sort of issue that would typically have been associated with the Legal function – but this is just one indication of how fast the role of in-house legal is altering.
Second, the broader rationale for this move is to enhance (or protect) Microsoft’s reputation in an environment of growing public hostility to Corporate ethics and practices, especially in matters of finance and income distribution. So expect much more of this type of initiative, as others jump onto the bandwagon and try to build their reputation. What might come next? Perhaps push-back on zero hours contracts, or demands that workers receive health coverage, or insistence on specified minimum wages? And issues around ‘ethical practices’ won’t stop there. What about caps on executive compensation, or limits on employee bonuses, or elimination of tax arrangements that are viewed as ‘unfair’?
Third, just think of the practical issues associated with implementing and managing the Microsoft requirement. Even if there is agreement on what constitutes ‘substantial work’, can suppliers really start to differentiate among their employees in this way? Issues of morale, employee relations and potentially litigation would suggest that Microsoft suppliers will have little choice but to change policy for all their US employees. And can they limit geographically? Indeed, can Microsoft justify the geographic limit to US workers?
Microsoft say that they recognize the potential cost impact of this change and are willing to negotiate with suppliers accordingly. Other customers may not be so happy to follow suit. So that leaves a supplier wanting either to pass all resultant costs onto Microsoft, or of having to accept a potential hit on margins. It will be interesting to discover how Procurement at Microsoft has been instructed to deal with these situations and in what way their measurements are being adjusted; for example, will Procurement continue to be measured on savings, or increasingly on maintaining corporate reputation?
Finally, if you think this move will be complicated to manage, just imagine what it will be like when others start jumping on the bandwagon. There is little point in them following the Microsoft approach – it is no longer newsworthy. So each initiative needs to have originality – and imagine for a moment what that could mean for suppliers. How can they possibly manage in a world where individual customers start to set rules for personnel policies and broader business practices. For example, Oracle may now say they don’t want to deal with suppliers who avoid taxes through offshore operations (unlikely I know, but I use it simply as an example).
As the Corporate world awakens to the need to rebuild public trust, we have to anticipate a mass of sustainability initiatives – and it is hard to see how they can be achieved without significant cost and price increases.
Procurement, legal compliance, accounting, marketing … These are all necessary activities within a business. The problem comes when those activities become enshrined within rigid policies and practices which are not well aligned and then undermine business goals and performance.
A recent report from Deloitte illustrates this point perfectly. It is just the latest in a number of audit reports that highlight how procurement practices damage economic results, frequently overwhelming the declared ‘savings’ that are generated by today’s Procurement functions. Yet when you review the causes identified by the study, most Procurement groups would deny responsibility: the problems are associated with poorly defined objectives, unbalanced allocations of risk …. ‘Not my job’ will be the reply. ‘That’s because of senior management, engineers, lawyers ….’. And in fairness, they are right – because the real problem is that process responsibilities are not aligned and the business lacks holistic insight.
This immediately illustrates the point that we must distinguish competency to perform a task from the assumption that it will then be achieved by a specialist business function. Firstly, the job title frequently does not reflect the span of responsibility. Secondly, there is a very real danger that the specialists become a barrier to good performance because their practices become sacrosanct, rather than the quality of their output.
Output is often hard to define and measure. You need to find critical indicators. That is why IACCM promotes the idea of measuring contract performance. Contracts are, after all, tangible assets – far more so than the sales revenue forecasts or procurement savings that are such a focus today. Smart organizations take these predictions of contract performance and monitor the actual results. More importantly, they explore and analyze the reasons behind performance gaps.
Contracts represent an overall measure of business effectiveness since every activity within the business contributes to them. If looked at through the lens of the contract, almost any shortcoming – or success – can be tracked back to its origin. This analysis, when the results are considered, quickly starts to reveal the practices and processes that are out of step with business needs – or which should be promoted to ensure success.
Increasingly, analyses are pointing to issues like insufficient stakeholder engagement, selection of the wrong supplier, use of the wrong incentives, inappropriate allocations of risk, over-commitment of resources …. All of these are readily evident from analysis of contracts that fail or underperform. Yet rarely are such analyses undertaken. Why? Ironically because contracting is one area where there is rarely a defined process and even more rarely any point of accountability for overall performance. While individual contracts may have ‘owners’, these unfortunate people typically do not receive substantive guidance or support. Indeed, the contract they are handed is frequently flawed from the outset due to the various policies and practices that governed its construction .
‘Commercial excellence’ is a term that every business leader should adopt. They should see this in terms of whether their organization’s contracts are delivering intended results. They should be demanding insights to the causes of under or over-performance. Essentially, business leaders need a small team that undertakes forensic analysis into business policies and practices as they relate to performance on contracts. Their key target should be to drive incremental revenues and cost reduction through improved performance of the contract portfolio.
You don’t have to search far to discover all that is being written about increased complexity in today’s business world. At the top of the list come issues such as managing interconnections and interdependencies – many of which cross traditional boundaries of language, culture and commercial norms. Networked technologies and social media mean that we cannot any longer ignore diverse stakeholder opinions. Old assumptions that power will prevail are no longer true – so is empathy the new source of strength?
Last week I attended a conference run by the Wharton School in Philadelphia. Its focus was on megaprojects – and this name alone conjures up an image of complexity. Time and again, presenters emphasized the importance of stakeholder management and engagement. We discussed the many challenges of understanding and reconciling diverse perspectives, especially since most megaprojects are focused on infrastructure development, which is often contentious. Developing mines or oilfields, building rail networks, roads, power stations … these are the types of initiatives that seem good in concept, but may meet violent opposition from local communities, environmentalists, religious groups or political opposition.
If we fail to address those stakeholders, our project is at risk. Modern media means that no voice goes unheard. Campaigns can arise from the smallest beginnings.
While it may not be possible to address every stakeholder’s wishes, we can – and must – bring them to a point of reconciliation and acceptance. And I would argue that this goes to the heart of good commercial and contract management. The job of a commercial / contract manager should be to avoid disputes – and to do this, they have to understand diverse perspectives and anticipate likely reactions, both within and outside their organization. Such considerations are already having major impact on contract and negotiation practices. For example, the growth of local content or offset arrangements are no longer simply about keeping Governments happy, they are increasingly focused on bringing direct benefits to affected communities. In addition, there is growing need to consider not just the impact of the construction itself, but also the entire aftermath of commissioning or decommissioning – people want to know these things in advance. And even when it comes to negotiating or contracting with local communities, there are many lessons to be learned. One speaker explained how they provided a community with negotiation training so they would be equipped to have effective discussions on the issues to be resolved. Another spoke about the need to have highly adaptive approaches to contract content, wording and terms – for many markets, large corporate contracts appear very threatening and undermine trust. They also contain many terms or assumptions that simply cannot work – such as the need to link to an ERP system or to take substantial insurance.
Good contracts and commercial relationships have always depended on a readiness to listen and understand the perspectives of others. I think this used to be a skill that many contracts, commercial and legal staff possessed. Unfortunately, the imposition of rules, standards and compliance have transformed the discipline to one of imposition, rather than understanding. And this regularly undermines the value we can offer. It is time for commercial staff to develop their skills in empathy. And then we would be welcome members of every project team.
Commitment Matters 