Continuing my theme of the role of contracts in the management of change, another example is in the field of supplier selection and ensuring that a trading relationship does not result in reputational or regulatory exposures.
Many organizations are struggling with how best to include this risk in their overall processes. The challenges they face include how best to identify risk severity, how to then incorporate identified risks into supplier selection and the process for on-going governance and oversight.
McKinsey illustrated this growing need in a recent article that discusses supplier risk and suggests a six-step plan for its management. They use the Financial Services sector as an example since the need there is especially extreme. Interestingly, I find the McKinsey view rather inward-looking. It makes no mention of how the trading relationship itself might be impacted, except in the most generic terms, and it does not discuss the extent to which implementation requires fundamental changes to the contracting process and terms (surely, if nothing else, making this a seven-step plan). Nor does the article consider the responsibilities – or opportunities – that today’s regulatory environment offers to suppliers and the fact that the best of them will be competing on their superior compliance capabilities.
In the end, improved supply risk has to be tackled through the contracting process. For example, having identified sources of potential exposure and their severity, they need to be incorporated into business requirements and supplier selection. The weighted factors for choosing a supplier must change dramatically – price becomes far less important than reliability and capability to avoid reputational or regulatory exposure. These criteria then flow through into contract terms. Whereas the finance industry cannot absolve itself from risk, it will certainly expect suppliers to make commitments in at least two key areas:
1) through terms that enable high levels of transparency on operational quality. These will include things like rights of audit, communication and reporting procedures, revised KPIs, shared approaches to problem resolution – in fact, many of the factors we use at IACCM to define ‘relational contracting’. Most of these are measures to reduce risk probability.
2) increased allocation of risk consequence. Inevitably, the customer will want suppliers to feel the pain if their actions – or inactions – cause an exposure. This drives towards tougher negotiations on the traditional areas of liability, indemnities, liquidated damages etc.
What does this mean for broader contracting strategies? One thing we are observing is that customers are becoming better at segmenting their supply relationships. They need to ensure greater rigor for those suppliers who represent the highest risk. On the other hand, they cannot afford to spend so much time on negotiating with the low-risk suppliers. So the smart approach is to relax some of the onerous risk terms at the low end (and reduce the need to negotiate) and to focus efforts on the high end.
For suppliers, the opportunity is to differentiate through superior performance capabilities. In general, these customer concerns tend to favour the bigger suppliers because they share an obvious interest in avoiding reputational damage and they have the resources to build capabilities. But in a sense, big companies also face greater problems. Their very size can make it difficult to maintain full oversight and ensure integrity throughout their operations. Overall, suppliers must design operational quality into every step of their procedures and those who pro-actively offer superior reliability and governance can win new business. That superior reliability and governance is primarily evident in one place – the contract.
Yesterday I wrote about using the contracting process to drive alignment with business goals. I highlighted how contracts are often seen as an impediment to getting business done, but in truth that is because of mismatches within the organization.
An example of this is the attitude to risk, especially within the Finance community. Over the years, I have encountered many situations where Finance imposes rules that directly inhibit the business and resists the need for change. Examples range from topics such as tax and inter-company to approaches to pricing and discounting. Within Finance, the aversion to losses can often prevent the realization of gains.
A recent example of this is the dislike of the Finance community for contracts that are not clear about allocations of risk. They have a strong preference for contracts that either impose risk on the supplier (when they are buying) or place responsibility for performance on the buyer (when they are selling). They see any ‘shared risk’ approach as inherently risky, even though there is no data to support this view. Apparently this attitude has been a key factor in undermining the use of more collaborative contracting models.
In my earlier article, I highlighted the choice that faces the contracts function or experts. They can of course sustain this view by Finance and simply impose this preference for risk allocation. Alternatively, they can take the view that it is their responsibility to understand the impacts that different contract and risk models have on performance and to educate Finance accordingly. There is extensive evidence that the approach preferred by Finance regularly damages financial results, in terms of both costs and profits, yet their position is rarely challenged.
Few would disagree that business undergoes continual change and that we have been experiencing an environment of particular turbulence.
It is inevitable that business structures struggle to keep pace with the changes going on around them. Many of these cannot be anticipated and their effect is often cumulative. As a result, wherever we turn – skills, processes, systems, policies, practices – we find gaps and shortfalls in capability. The ambitions of our business leaders are typically far ahead of the ability of their organization to execute.
Within this environment, contracts and their management are increasingly seen by many as contributing to the problem. The process through which contracts are produced or negotiated is perceived as inflexible, bureaucratic and therefore a symbol of all that is wrong. And indeed, it is frequently true that the contracting process becomes an impediment to doing what we need and the contract itself becomes misaligned with business strategy or market requirements.
In truth, the contracting process can never be more than the sum of the component parts of the business. Contracts reflect capabilities, they don’t create them. Those who are charged with establishing and documenting business commitments cannot alter the realities of existing skills, processes and systems. Their job is in many ways to protect the business from its natural over-optimism and in performing that task, they will rarely be popular.
But in a well-run organization, those who are charged with contracting can and should be at the forefront when it comes to identifying and challenging lack of capability. The contracting life-cycle offers potential for invaluable insights to the mismatches that occur in an era of rapid change. To that extent, the people responsible for contracts do indeed have a choice – they can defend the status-quo, or promote change.
In coming days, I will highlight a few examples of the types of issues that analysis of contract experience can offer and thereby become a source of strategic capability.
For most organizations, the process of developing terms and conditions and deciding related policies is largely an internal activity. There may be some reference to industry norms, comparison with competitor standards, advice from outside counsel or influence from an external consultant. But mostly, contract terms just tend to evolve based upon discussion between internal stakeholders.
Recently an IACCM member approached me to seek help with developing a customer forum which they titled “Achieving Value from Improved Contracting”. Intrigued by the data IACCM has produced on the costs of poor contracting (costs which negatively impact both customer and supplier), they decided that the best way to develop an improvement to standard terms might be through an open discussion rather than through individual negotiation and they asked whether I would act as moderator.
There were about 40 participants at the event, a mix of Procurement, Finance and Legal staff from some of their largest customers. The agenda covered a number of specific clauses as well as several contract-related themes. For example, one topic was ‘Payment terms and Invoicing’, in which trends and impacts were discussed. This session included IACCM research into the standard approach at the participating companies – with data anonymity, of course. This offered delegates a different perspective; most had not realized the extent of the divergence in their own practices or considered how their term and condition demands can impact things like invoice accuracy.
Not surprisingly, the topic of risk allocation generated lively debate. The extent of IACCM data on this topic, together with evidence from a top consultancy, helped participants to grasp the benefits of a more nuanced approach to risk terms, based on what they are trying to achieve. This led to sessions in which delegates explored some of the terms that help cause or avoid value loss in contracts and a round-up presentation that sought opinions on potential new offerings – for example, greater use of digital technologies in contract formation and distribution, as well as the potential for performance or benefits-based contract models.
Before the event, there was some nervousness about bringing customers together in this forum. Would they start complaining or making adverse comparisons with competition? Might they ‘gang up’ either at the event or afterwards to push for new approaches? In the end, none of these fears were realized. Instead, the customers had a new appreciation of the impacts of term choices; they felt their voice was being heard; and overall, contract terms were suddenly no longer a taboo subject, but instead a recognized source of added value.
For the forum organizer, the benefits were many. They included invaluable market insight, a stronger customer relationship, future reductions in negotiation and contract cycle time, improved cooperation with sales and account management and an enhanced understanding by top management of the role that contracts can play in the business. Not surprisingly, plans for the next two forums are already under way.
When it comes to selecting a supplier, how important are the terms and conditions? Does it matter what approach the supplier takes to negotiation? Does ‘the contract’ really make much difference?
The answer to these questions varies. To some extent, it depends on the attitudes and policies of the customer organization. Perhaps more important is the nature of the deal or transaction. IACCM is running a number of studies that will look at questions like these from the perspective of both buyers and sellers. In addition, these studies will compare the approach of major companies within an industry, to identify the extent to which their approach may be a significant source of competitive advantage (or disadvantage).
The first study looks at major outsourcing and IT services providers. Many customers in this sector express concern over the inflexibility that suppliers show towards negotiation, with almost half frustrated by the lack of authority in the supplier’s negotiating team. In fact, it is the issue of responsiveness, closely followed by a feeling of being treated ‘as a business partner’, that customers most value when distinguishing between supplier approaches to negotiation.
When it comes to terms and conditions, data protection has risen to the top of the ‘critical’ list. Over 70% indicate that this is an are where suppliers must satisfy customer needs, with service levels taking second place among the most important terms.
The survey remains open for completion by anyone who has direct experience of negotiating with major outsourcing or IT service providers. It can be accessed here.
In an article, “Thinking Twice About Price”, The Economist suggests that very few companies have a formal pricing policy. While I disagree with this contention (I have never worked for or with a company that did not have policy in this area), my experience is that very few have a pricing policy that is effectively linked to a commercial strategy.
The Economist makes the point that there are three core ways in which companies can seek to improve. One is through increased sales; another is through cutting costs; and the third is via higher prices. They suggest this third route is frequently overlooked and proceed to offer examples of ways that pricing should be used in this ‘age of austerity’, since the other two mechanisms may no longer be effective.
However, the examples that The Economist then offers all reinforce the point that it is commercial strategy, rather than pricing policy, that is missing. For example, they highlight the sales-at-all-costs mentality that prevents companies walking away form deals; or the failure to link price with distinctive value propositions; or the ineffectiveness of market segmentation that leads to a ‘one price fits all’ mentality; and the failure to consider ‘unbundling’ so that customers can select the options that they most value.
These areas – and others – have each been discussed at some point in this blog, not in the narrow context of pricing, but rather as elements of a commercial strategy based on market understanding. To me, the problem is not lack of pricing policy; it is once again the tendency to develop ‘specialisms’ that operate independently within the business. How can a ‘pricing expert’ ensure maximum returns if they have little or no insight to broader market considerations? They are limited by their expertise, in just the same way as the lawyer, the project manager, the category manager or the myriad of other ‘specialists’ that populate business today. The real issue is the absence of the commercial oversight that should be offered through a generalist asking the right questions and challenging the narrow wisdom of ‘the expert’.
Guy Strafford has written an excellent article in the Proxima newsletter, asking whether the name ‘Procurement’ is toxic.
As Guy acknowledges, he is by no means the first to raise this question and indeed there are several articles in this blog raising similar points. A few months ago, I highlighted the issue of functional name, with the observation that efforts to shift from Purchasing to Procurement to Supply Management etc. could be seen as steady maturing of the role and skills, or an attempt to escape reality.
The fact is that executives seem unwilling to change the underlying measure (savings) which does so much to undermine the value that Procurement delivers. And perhaps this is not going to change – maybe this specialist focus is exactly what executives want.
The problem this creates is when the business – or indeed the Procurement function itself – then expects a wider role – for example as ‘commercial managers’. In order to gain real and sustained value from trading relationships, there needs to be a level of oversight, understanding and judgment that a narrowly measured function cannot provide. This is true of Finance, Legal, Risk Management and many other groups. Specialism and focus does not mean there is no value – but we have to recognize its limits.
So to Guy’s point, I think perhaps the advocates of Procurement are creating false expectations regarding what they can deliver. It is this disappointment that then makes the role ‘toxic’. Rather than claiming a capability they do not have, many Procurement groups may be smarter to get on with doing what they do well, and pointing out to management that if they need business coordinators, people with balanced commercial judgment, then they do indeed need to develop a new group or function. Maybe it should be called Commercial Management or even Trading Relationship Management; and in my opinion, its mission should be to enable success across all trading relationships, buy and sell.
Henrik Lando, a professor at Copenhagen Business School, recently sent me an article ‘The Cost of High-Powered Incentives: Employee Gaming in Software Sales’.
The paper is written by Ian Larkin of Harvard Business School, to be published in the Journal of Labor Economics. In his introduction, Assistant Professor Larkin explains the goal of his research: “It is well-known that employees “game” incentive systems by taking actions that increase their pay but hurt the objectives of their employer…… This “timing gaming” can affect business outcomes by changing revenue flow, pricing, or other key variables in ways beneficial to the employee but detrimental to the firm.While the prevalence of “timing gaming” is well-known, little is known about the scope or cost of this gaming to employers”.
This hypothesis in – in my experience – certainly correct. Any one involve din contracting – buy-side or sell-side – is well aware of the quarter-end banana curve and the year -end flurry in sales, driven by bonus schemes and incentives. Indeed, many buyers quite deliberately defer purchases and ensure that they sign only at the last minute, to extract maximum savings.
So what is the scale of the distortions that are created by today’s sales incentive schemes? Professor Larkin discovered that “salespeople agree to significantly lower pricing in quarters where they have a financial incentive to close a deal, resulting in mispricing that costs the vendor 6-8% of revenue”. He concludes that “salespeople with strong financial incentives to close a deal in a given quarter appear to grant discounts that are larger than necessary to win the deal in order to guarantee that the deal closes on the salesperson’s preferred timeline”. Indeed, I would suggest that this finding significantly understates the full cost. From IACCM research, we know that the weighting of business to quarter end creates massive inefficiencies in workload and puts tremendous stress upon processes and other areas of compliance and contract quality. I suspect that if we looked at downstream error rates, claims or disputes, many would tie back to the non-standard agreements and panic deals that are struck in those final few days of the quarter.
This topic certainly merits further investigation. What is unclear to me is whether businesses can really extract themselves from this game. Their customers now expect it. And indeed, I suspect that senior management in the supplier community is well aware of what is happening – so perhaps they have already elevated prices to take account of this perverse approach.
In a world where discounts and savings seem so fundamental to perceptions of value, ‘gaming’ of this sort is in many ways just a sort of bluff and double-bluff. But Professor Larkin’s work should cause any commercial expert to pause for thought and ask ‘Is there a better way?’
A current survey being conducted by IACCM reveals that contract and procurement specialists find China one of the hardest countries to deal with. It scores especially low on the topics of ethics and business culture and local laws and regulations.
This will come as no surprise to the management of GlaxoSmithKline, currently embroiled in corruption charges by the Chinese government. As this week’s Economist points out, it is almost impossible to do business in China without some level of ‘enabling gifts’ and it is often equally difficult to know when these are deemed to cross a line into actions that the authorities might deem corrupt. Indeed, some may wonder whether the tortuous thinking of the political elite may in part encourage such behaviour because of the control it gives them. By turning a selective blind eye to bribery and corruption, those in power not only gain personal benefit, but they also have a stick with which they can selectively beat anyone when the moment is opportune.
Do the authorities actually care about the actions of GSK (and other Western firms they are now investigating)? Or is their action prompted by a wish to boost local competitors, or perhaps to send a wider message of fear to non-Chinese corporations? Certainly there will be many wondering whether they are next in line.
Ultimately, the size of the Chinese market makes it difficult for companies to ignore. But the difficulties of controlling local employees, the unpredictability of local laws, the challenges of understanding and the arbitrary behaviour of officialdom certainly represent high levels of risk – not to mention the traditional concerns over intellectual property. At what point will inward investment seem too unpredictable?
The Economist also ran an interesting analysis of whether major corporations benefit from exposure to the Chinese market. This year, the stock price of those with significant investment and sales in China has substantially under-performed. So perhaps the combination of factors will be causing many to reduce their exposure to this difficult market.
To participate in IACCM’s survey on ‘Doing Business Internationally’, visit https://www.surveymonkey.com/s/intcontracting2013
Yesterday I was reading some articles that I started and never quite completed. One of them contained this summary of a conversation I had at a meeting of the International Centre for Complex Project Management (ICCPM) in 2012.
Professor Mike Jackson had made the introductory presentation in which he emphasized the need for project management to embrace ‘holism’ and to “Escape reductionist thinking”. As he spoke, I was struck by the similarities to contracting and commercial management – and also the interdependencies between our disciplines.
‘Holism’ is based around systems thinking and the need to synthesize, rather than analyze. It therefore seeks to avoid focus on component parts and to concentrate on the interactions needed to secure the overall desired outcome. Such an approach would – for example – place far more emphasis on the importance of sustained leadership, communication, commitment and planning to project success, and less on requirement management and individual components.
As I thought about this in the context of contracts, a number of points struck me. First, a ‘holistic’ contract is made up from many clauses and terms which exist individually, but impact outcomes cumulatively. Second, the input to contracts comes from many and varied sources, each of which may have a distinctive view of what it considers ‘success’. Third, projects (and therefore the contracts that underpin them) are ‘incomplete’ until they are finished and therefore require continuous oversight and revision to maintain ’holism’ or integrity.
The meeting discussed the challenges faced by Project Managers. Some of these related to a lack of the skills and knowledge needed to undertake ‘holistic’ management. Others involved issues such as the timing of engagement and failure to focus on critical dependencies, such as leadership risk or cultural risk.
Listening to the problems caused me to reflect on similar issues in contract and commercial management – in particular, the question of’ ‘excellence’. It struck me that an excellent contract or commercial manager is someone who engages in holistic thinking. They see the big picture and the interdependencies. They do not allow themselves to be side-tracked into excessive debate on individual clauses and functional position, but see their role as communicating, leading, planning and gaining commitment. To do this, they must understand individual ‘reductionist’ stakeholder views and find ways to reconcile these with the broader needs of the project. They emerge with a balanced contract, designed to cope with change.
Of course, this excellence is far from universal and many contracts groups remain tied to specific interests (for example, legal or finance) and lack the vision to expand from a focus on ‘requirements’ to a focus on ‘outcomes’. Often, there is no synthesis of the entire contract; different groups produce different parts and ‘quality’ means that it has been checked for inconsistencies, not that it is truly ‘fit for purpose’. As a result, project teams are given contract forms and standards that provide poor and inadequate tools for on-going management.
How might we improve? One approach will be to focus on continuing improvement in the standards of contract and commercial managers. In this regard, the growing adoption of a common perception of the role and a consistent body of knowledge is a major step. But it strikes me that a second critical aspect is the creation of collaborative relationships with others within our ‘reductionist’ universe. Functional specialism is by its nature ‘reductionist’. What all of us must do is to understand better how we fit our specialism into a holistic frame. And it may well be that commercial managers and project managers are key to creating this synergy, since each of them may have the role of harmonizing across specialist groups to ensure that a level of reconciliation is achieved and maintained, to allow desired outcomes to be achieved.
Commitment Matters 