ISG recently released a brief report on 2012 trends in outsourcing. They comment upon the divergence between markets, which inevitably reflect the variations in economic conditions and business confidence.
In Europe, much of the focus appears to be on cost-cutting, with pressure for utility pricing, limited commitments and short-term returns. Asia is also experiencing anxiety over costs and flexibility, as they deal with a rapid slow-down in local markets and regional growth predictions. This has apparently led to ‘innovative contracting’, with a trend towards ‘assured outcomes’ and strong focus on IT outsourcing.
This leaves the US as a market that continues to cut back on its use of outsourcing and shows far more interest in innovation and transformation. This perhaps reflects the growing confidence of US business that it can effectively compete with new global competitors. This has lessened the need for labor arbitrage in previously low-cost markets and increased the pressure to develop new products, services and business process.
For providers, market conditions remain tough, with significant competition and the need to manage the complexity of divergent markets. However, as the report indicates, there is a growing ability to differentiate not only in terms of the services offered, but also in the range of contract structures and commercial offerings.
Yesterday I presented at a meeting of supplier relationship managers. My theme was ‘Driving Contract Performance Through The Fear Of Failure Just Doesn’t Work…’ and it focused on the need to understand how contracting practices influence behavior and outcomes.
I started by raising questions over the importance of contracts and one co-presenter was quick to raise her hand and tell me ‘We don’t have contracts with our key suppliers’. We had a brief discussion about the implications of ‘no contract’ and it later emerged that while this company has no traditional agreements, it does have a disciplined approach to defining the relationship and how it will be managed. Not surprisingly, there are also documents that sound very similar to Service Level Agreements and Statements of Work.
So in the end, there are essentially ‘contracts’, even if the organization chooses to call them something else. And if they feel this in some way contributes to better relationships with their suppliers, I think that is fine.
The real point here is that contracts matter far less than the contracting process. A good contracting process evaluates how best to structure and manage an organization’s assets – and those assets include their trading relationships. So if you can manage risks and achieve better results through non-traditional forms of agreement, then that is the right decision.
A problem at most organizations is that they tend to have a standardized approach to contracts which rarely allows for discussion of commercial alternatives. As a result, anyone deviating from the system often does so without having adequately explored the implications or alternatives.
I am excited about the break-throughs we are making in truly defining the value of contract management. Or to put it another way, the cost to organizations when they fail to develop strong capabilities in this area.
In previous blogs I highlighted IACCM’s early research into the return on investment from contract management. This was interesting and ground- breaking. But it was also generic and therefore begged the question “Is this really representative of my organization?”
The new news is that an increasing number of IACCM member companies are using those initial insights as a springboard to undertaking detailed internal analysis of their contract portfolio. This may be though a targeted effort, say focusing on a specific category of contracts, or it may be across the board. Some have examined just 20 or 30, while others have started to monitor and track thousands.
The important point is the results, which largely support the initial research findings. They confirm that there is tremendous value waiting to be mined through improved contracting practices and process. Buy side and sell side analysis both reveal large potential for bottom-line benefits. For example, one large corporation discovered that some 29% of its sales contracts underperform. They also identified six key areas that led to this – and that the average underperformance was 22% of planned revenue. Now a plan is in place to tackle this leakage, with the expectation that it can be halved this year. That will bring approximately 2.5% extra revenue to the bottom line – or around $500 million.
In order to gain these rewards, a business must shift its attitude to contracting and see it as a process. Improvement comes from analyzing the contracts portfolio to identify reasons for loss and then, of course, taking steps to fix them. This may require redefining roles within the organization. It certainly demands a shift in appreciation of the value of contracts and that the process can be used to test internal performance.
Here is a brief example. One area where there are frequent problems is contract scope. Weaknesses in definition cause disagreements between buyer and supplier, with many negative consequences. So this calls for further thought about the way requirements are identified, analyzed and discussed, as well as the process and people through which they get documented. But while this will yield improvements, it will also reveal the fact that today’s fast-moving business environment means that scope will often change. So the parties actually need to think about the post-award mechanisms through which change – and associated risks and costs – will be better managed.
Many of the sources of loss are actually much simpler than this one. They are due to terms that were omitted, or unauthorized discounts that are processed, or personnel who have not received training or have no access to commercial guidance.
As I mentioned at the beginning of this blog, I am excited by what we are discovering because at last there is a compelling executive message. Contract management is a critical source of value realization – and we can show you the money!
What are the underlying principles that drive contracting behavior and attitudes at your organization? And how important is the role of contracts in delivering business value or organizational goals?
These are questions that a current IACCM survey seeks to answer (Click here to view or complete the survey). It is clear that the factors influencing contract policy and practice vary widely – and this may increasingly be true in the division between Government and the private sector. For example, this quote from the UK’s Guardian newspaper illustrates one aspect of the divide: “Central government’s primary driver is still cost reduction. Yet whilst cost reduction is still one of the private sector’s top five drivers, other drivers such as increasing customer satisfaction and innovation in order to attract new customers are rapidly gaining in importance.”
IACCM observes growing evidence that organizations appreciate the importance of revising their contracting practices and process, in some instances to raise efficiency, but in many cases to generate better business results. Yet conflicting views and drivers make it more difficult to negotiate and build sustainable relationships. Our survey will reveal the current trends and to what degree they are affecting particular industries or geographies.
This year has seen big changes in the world of patents, with significant developments in the US and the EU.
After years of discussion, the EU accepted the need for a unified system that overrides the previous need to register country by country. The Unitary Patent should be in effect by early 2015, making the filing of patents within the EU far ore attractive and massively less time-consuming and expensive.
At the same time, with effect from last March, the US was overhauling its system under the auspices of the America Invents Act. An important feature of that Act is the ‘ first to file’ principle, which is certainly likely to boost the number of patent applications.
Globally, the use of patent systems to protect IP continues to gather pace. The World Intellectual Property Organization (WIPO) reported 10.7% growth in 2011 and 6.6% in 2012. Of course, it is not possible to know how many of these patents have real merit and to what extent they will be used in efforts to prevent competition or extract money from real inventors. At least one encouraging piece of news was last week’s Execution in the US to limit ‘patent trolls’.
WIPO also commented on the drive by corporations to register intangible assets since these now play such a large part in market valuations, Certainly this implies negotiations over IP rights will remain high on the agenda for the ‘most negotiated terms’.
Of particular interest is the extent to which the source of new patents is changing. For example, last year, the top four filers of new patents worldwide were all from China and Japan (ZTE, Panasonic, Sony and Huawei). Almost 40% of patents came from China, Japan or South Korea – up from less than 8% 20 years ago. If these intangibles genuinely do reflect relative wealth and value, this is a major reinforcement of the shifting global balance.
In previous blogs, I have referred to the opinion of Lou Gerstner, former Chairman and CEO of IBM, that ‘contracts are about brand image’.
Gertner’s point – which I consider very insightful – was that organizations must achieve alignment between the ‘marketing promise’ and ‘the contractual commitment’. Far too often, this is not the case. The implied values and promises that are delivered via the marketing and sales channel are then compromised or overturned by the small print of the contract. Gerstner grasped this point at a key transitional stage in IBM’s history, perhaps because of his consumer-oriented background. The corporation faced a dramatic surge in competition. It had customers demanding integration, inter-operability, global consistency and capability. IBM was seeking to respond, offering ‘solutions for a small planet’. But for the customer, those enticing words rapidly proved to have little substance.
First, the contract denied inter-operability. The customer took responsibility for operational performance via a ‘selection and use clause’. As for consistency, each country defended its autonomy by insisting that their market was different and therefore the range of features, functions, support services had mushroomed out of control; no one had any idea what could or could not safely be committed in terms of product or service availability. And that was just the start of the customer nightmare, because each country also made local contract variations; Finance wanted to exploit international price differences; and local operations and IT groups felt the necessity to develop local systems and support that allowed no central visibility. ‘Solutions for a small planet’ was actually more an indication of everything that was wrong with IBM, rather than a description of value and capability. A great concept, but not a reflection of reality.
You might think that groups such as Marketing, Sales or senior management would have rapidly grasped this point. But instead they saw ‘commitment reform’ as far too difficult. Sales were taught to tell the customer ‘Don’t worry about what the contract says, it’s what we do that matters’. And management invested in Special Bid teams and expert flying squads of negotiators who were similarly disempowered in practice. Those who ‘owned’ contracts (the lawyers and Business Practices staff) saw themselves as custodians of the status quo, not change agents. Indeed, the customer was seen as ‘trying to game us’ (in the words of one senior executive in Finance). Only with Gerstner’s backing did fundamental change prove possible, using an analysis of customer commitment requirements to drive reform of policies and practices across the business. Until that moment, contracts were indeed ‘an inconvenient truth’ – focused only on reflecting the business reality, rather than being used as a tool to drive a response to validated market need.
This seems to me to be true of so many corporations even today. The failure by Marketing to grasp the fundamental connection between their efforts and the role of the contract means that often companies generate an aura of dishonesty. Far from engendering confidence and trust, contracts tell the unfortunate truth.
As a post-script, it should be noted that IBM’s re-engineering efforts proved highly effective and restored its market position. It rapidly turned its international presence from a source of problems into the source of competitive advantage that it needed to become. The development of a strategic view of contracting – and creation of global capability in contract management – was a significant contributor to that success.
In a succinct blog, Ken Adams reminds us of the importance and the limitations of the law when it comes to its role in contracts.
The summary Ken provides is important because it illustrates the many things that the law does not do – and by deduction, things that you cannot assume a trained lawyer will address (though of course some will). The law does not impose any duty of common sense or good business judgment. It does not create a duty of clarity. It does not mandate that records or understanding must be complete. In other words, the law is all about making judgment based on established principles of equity and legality.
Ken’s observations reinforce the point that a traditional lawyer is but one stakeholder in the process of constructing a contract. They bring invaluable, but narrow, perspective and insights, largely focused on ensuring enforceability of rights. Of course a business may choose to expand this role and demand that its lawyers also apply wider skill and knowledge – but then it must be clear about that scope and what it considers ‘success’ will look like. Often, the role and expectations of the law department are extremely vague and depend on the perceptions and whim of the individual attorney.
This confusion helps no one. Lawyers are frustrated because they feel that the business people are abdicating responsibility for making business judgments. The business people are frustrated because they feel the lawyers are reluctant to give expanded opinions. Once upon a time, the list in Ken’s blog was a good reflection of the type of contract review lawyers would undertake. Today, they engage far more – but too often in an unpredictable way; and that helps no one.
It has been interesting to observe the steady proliferation of functional names and job roles within the overall area of purchasing. Does this reflect a growth of value and an expansion of role within the business? Or is it because of confusion and attempts to display value? And of the titles now on offer, is there a meaningful distinction between them and the contribution they make, or are they interchangeable?
In many cases, it seems that ‘specialist’ groups emerge because they want to distance themselves from the mass of their colleagues. ‘Purchasing’ was deemed too administrative, so there was a trend to change the name to ‘Procurement’ which was somehow deemed more managerial. Then came ‘supply management’, which might be a job in its own right, or could be an umbrella term covering all areas of purchasing activity, including Logistics. In addition, there were splinter groups such as IT Procurement, or specialists in Outsourcing, or the more recent Supplier Relationship Management.
Today, the more ambitious and creative members of Procurement teams often want to distinguish themselves from the process-driven world of compliance, commodities and category management (though there are Category Managers (yes, another title) who would argue that they are in fact the ‘commercial core’ of the function).
It is hard to know what we should make of all this, except it confirms the trend in many areas of business to become ‘a specialist’. Somehow, we appear to believe that there is greater safety in being distinct from ‘the masses’ and boasting specific knowledge or expertise. The problem for Procurement is that it is not really deemed a true profession. Lawyers, doctors, engineers and accountants have an over-arching title that is recognized and respected. Being ‘a Procurer’ does not have quite the same ring – nor would most people feel flattered to be called one!
In the end, I do think these shifts in title are reflective of efforts to raise value. The journey is unending, but right now it is clear there is widespread concern that procurement practices are too mechanistic, too driven by process adherence and too little driven by commercial judgement. Even CIPS has acknowledged this fact (the need for greater commercial acumen). So will ‘Supplier Management’ provide a wider array of skills and new sources of value? It does seem to me that there are genuine trends towards a more outward-looking, analytical function that takes greater responsibility for the outcomes of its work and which seeks to build understanding and empathy with suppliers. This is in part evidenced by the numbers now joining groups such as Procurement Leaders and IACCM, where they gain new and more expansive knowledge.
Process is important, indeed it is integral to good and efficient operations. But it is the baseline, not the end point. To flourish, Procurement must become far more than a process owner. It must use that process to support an ability to solve problems, undertake analysis, communicate effectively with stakeholders, facilitate supplier dialog and develop strong relationship skills. If that is achieved, functional names and job titles will become far less important.
There is a small, but growing, understanding that improving the performance of trading relationships depends not only on a sense of economics, but also greater understanding of psychology.
I have frequently made the point that today’s contracts and relationships would benefit from more effective economic analysis. In particular, I have urged increased use of behavioural assessment. For example, liquidated damages, or onerous indemnity clauses, or unbalanced performance measures are terms which often undermine the results we are seeking. We structure and negotiate agreements without stopping to think what behaviors they will induce.
Further evidence of the importance of psychology in decision-making comes from an article in The Financial Times ((June 1st, ‘Beware the irrational side of your inner self’). While this focuses on investment decisions, many of the observations carry over into the world of contracts – which are, in essence, a form of investment. Apparently there is a growing science of ‘behavioural finance’, led by psychologists who have plenty of evidence that ‘we are far from rational when we invest’. Decisions are distorted by in-built biases and prejudices, which result in limited reflection or analysis.
The psychologists refer to the massive influence of ‘framing’ (which I am pleased to say receives substantial attention in the IACCM learning program). For example, we are innately attracted to high potential gains and tend, when these are on offer, to downplay the potential scale or probability of loss (an observation reflected in ICCPM’s work ‘A Conspiracy of Optimism’). On the other hand, human behaviour is generally risk-averse when there is a high degree of uncertainty. For example, if we are asked to gamble $100 with a 50/50 chance of doubling our money, most will reject the offer. However, our willingness to gamble again soars once we have actually lost $100 (and merely have the hope of recovering it).
Even brief examples such as these illustrate the tensions within organizations when they are considering contracts and the value of trading relationships. We have those who are seeing high potential gains and ‘framing’ accordingly. Groups like Sales inevitably see things this way, since they have bonuses to win, with little if any downside from a poor decision. There is evidence that business executives fall into the same trap, especially for large deals. On the other side, we have groups such as contract management and Legal ‘who assign less weight to opportunities that are merely probable in favour of those where outcomes are certain’. Since every deal has a degree of uncertainty, our inclination is to focus on protection, even though we may be increasing the chances of failure. We are skeptical and resistant to new techniques. For example, ‘relational contracting’ can be used both to improve partner selection – thereby reducing the initial uncertainty – and to increase the quality of governance – leading to a higher probability of success.
A final point of interest is that the behavioural scientists observe how rare it is for organizations and individuals to learn from past experience. This again reflects an issue observed from IACCM research. Few organizations seek to undertake portfolio analysis. They do not look at contract performance in a holistic way, to see what patterns emerge. In fact, there is a tendency to insist that every deal, every relationship is different and therefore offers no meaningful insight to what might happen in future contracts. That way, we maximize on-going uncertainty and continue to justify our in-built prejudices and biases.
So the real challenge seems to be that even when we identify solutions that can lead to better contracts and more productive trading relationships, how do we get anyone to listen?
Francis Maude, head of the UK’s Cabinet Office, recently gave evidence to a Parliamentary Select Committee on the subject of Government Procurement.
While showing some differences in the analysis of causes, the committee has been relatively united in its criticism of public sector procurement. It is of course always easy to focus on highly publicized failures and the media loves nothing more than to point to the waste and incompetence of Government employees and ministers. As I have observed in previous blogs, that analysis is generally unbalanced since private sector shortcomings are not subject to the same external visibility and to some extent poor decision-making is due to aspects of that external scrutiny.
However, Francis Maude was quick to acknowledge the need for further improvement and focused especially on the challenge of improving commercial skills. He rightly highlighted a number of the key challenges – one being the tendency by many Procurement staff to place process before judgment, another being the fact that you cannot centralize all decisions – so commercial judgment must be a quality that is widely dispersed. In this diagnosis, his evidence accorded strongly with that which I (and several other IACCM members) have provided to the same committee in recent weeks. It also aligns with the realization by many private sector executives that ‘raising commercial competence’ is a critical issue in meeting the challenges of today’s markets.
The challenge for Government remains in part where it should start. As the Minister indicated, a fully centralized procurement service is unlikely to work well, given the size and diversity of the organizations it would cover. But he was right to suggest that there are opportunities to consolidate certain types of spend or certain types of project. Consolidating skills does not mean that decisions are automatically divorced from user needs. This Government has also taken steps to introduce commercial understanding at higher levels of the organization, though I have some concerns that this will lead to frustration rather than change (it is certainly a tendency I have observed when private sector companies try this approach). Inserting private sector ‘experts’ is another recent measure which I suspect may assist diagnosis rather more than generating improvements for specific projects.
From my limited insight, I feel that major issues for Government procurement are based on fragmentation of resources and unclear accountability. Without these issues being addressed, it is not surprising that individuals are more concerned with ensuring they do their part of the process rather than worrying about the ultimate outcome. When it comes to commercialism, I think it is critical to remember that public sector employees largely lack insights to ‘the market’. That is because their survival does not depend on selling things. Many times, private sector Procurement staff are also weak on commercial judgement, but they have other forces throughout the business which ensure the wider market is not ignored.
So perhaps a key thought for Francis Maude – and other public sector leaders – is that seeking to emulate private sector procurement is missing the point. Public sector actually needs a different approach to developing the necessary acquisition skills. Perhaps if we started with training in commercial management and then added the techniques of modern procurement we would see different results.
Commitment Matters 