Contracts as a Source of Value IACCM 2009. All rights reserved. Page 1
Executive Summary Sustained investment in contract and commercial management disciplines will occur only when it is possible to demonstrate that they create and deliver value. The necessary evidence is now available our choice of contract terms has a direct and major influence on the financial results of the business. Economic value, innovation and cycle time improvements can be radically influenced by contracting strategies. Benchmarks and research show that employing the right contract structure and terms is not simply about containing unpleasant risks; it is also and predominantly - about achieving superior economic value from trading relationships. However, realizing this value depends on a shift in the way that contracting is managed and measured. This report illustrates how contracts have become critical weapons in today s highly competitive global economy. When properly structured and negotiated, they provide a framework for business and relationship management that significantly increases the probability of mutually successful outcomes for all parties, as well as containing the consequences of failure. The report concludes that transition to strategic contracting is achieved only through executive support, demanding new appreciation of the role of the contract and the resources associated with its creation and management. Tim Cummins Chief Executive Officer IACCM tcummins@iaccm.com (1) 203 403 9002 (US direct line) / (1) 203 512 0194 (US cell) (44) 1582 712602 (UK direct line) / (44) 782 3323859 (UK mobile) IACCM 2009. All rights reserved. Page 2
Introduction Most executives accept the need for contracts, but many see them as instruments for business control and asset management. The contract is viewed as a by-product of the sales or acquisition process, rather than a tool which is dynamic in determining business and economic outcomes. There is little grasp of the impact that term and condition choices have on results not surprisingly, because there has been no data to support improved understanding and decision-making. One CEO summed up the views of many when he stated We can have good relationships in spite of the contract. And another reflected widespread perceptions when comparing his contracts and negotiation staff to a dial tone something you really miss when it is gone. These views demonstrate the common opinion that contracting is a necessary evil, an activity that brings discipline and is demanded by governance and in some cases regulatory standards. Hence the resources charged with contract negotiation and management tend to be focused on controls and legal risk, rather than creativity and opportunity creation. An Alternative View Lou Gerstner, former Chairman and CEO at IBM, was one of very few top executives who have seen contracts as fundamentally linked to brand image. He believed that good contracting especially in a solutions and services world confers competitive advantage. His support led to extensive re-engineering of the contracting process at IBM and is reflected today the company s leadership in both negotiation and contract CONTRACT PURPOSE Clarity in intent Clarity in obligations Clarity in governance Clarity in expected benefits Clarity in the management of change management 1i (although his successors appear recently to have instituted a different path). Good contracts deliver clarity for both parties in areas of expectation, performance and resolution. In combination, these ensure that the contract provides a framework for business and relationship management which 1 See IACCM surveys of The Most Admired Companies, based on the votes of worldwide contract managers and negotiators (2008 and 2009). IBM topped the poll in both categories, for its sales contracting and negotiation. IACCM 2009. All rights reserved. Page 3
significantly increases the probability of a mutually successful outcome for the parties, while containing the consequences of failure. 2 However, most organizations have struggled to find the formula for consistently successful contracting. This often leads to frustration, especially in high-profile areas such as outsourcing, alliances and distribution. In many companies, the result has been a battle between those who want to impose inflexible standards and those who want specialist, autonomous groups with freedom to negotiate their own contracts. The top performers have moved beyond this organizational battle and are increasingly focused on ways to achieve excellence in all contracted outcomes. To achieve this, contracting must become a strategic discipline that drives transactional tactics. In many companies, the result has been a battle between those who want to impose inflexible standards and those who want specialist, autonomous groups The strategy of contracting is as Lou Gerstner understood about aligning contract terms and structures with selected market segments and opportunities. This does not mean abandoning standards quite the reverse. It means developing a portfolio of standards that support and enable desired outcomes. For example, a contract to deliver commodities is fundamentally different in its allocation of risks and obligations from a contract to deliver sustained cost reduction, or value-add services or innovation. Performance Impact Sustained cost reduction Shortterm Small Cost cutting Figure 1 Contracting Standards to Support Desired Outcomes (from Willcocks & Craig, 2009) 3 2 See, for example, the 2009 study by IACCM of the Most Frequently Negotiated Terms and the views of negotiators on which terms require focus in order to achieve successful business outcomes (IACCM, Contracting Excellence, July 2009) 3 Step-change: Collaborating To Innovate, Professor Leslie Willcocks and Andrew Craig IACCM 2009. All rights reserved. Page 4
Strategic Contracting Strategic contracting goes further than offering one-time alignment. Companies with a strategic approach actively monitor and benchmark the impact of their terms and conditions on behaviour and outcomes. This means collecting market and transactional data to provide management insights and to fuel on-going change and update. An exciting example of this new way of thinking is revealed in a recently released study of Performance-based Contracting. 4 Based on experience over a number of years, Professor Morris Cohen of Wharton School of Business was able to compare the relative performance of two contracting options for the same service. Customers could choose a traditional, time and materials offering or a performance-based commitment. Benchmarks have shown that the performance-based approach yielded significantly greater economic returns for the customer; but in addition, it acted as a strong incentive on the supplier to increase quality and therefore drove innovation. Economic value, cycle times, innovation are directly influenced by the choice of contract terms. It is clearly time for a more strategic view of contracting policy and practice. In this case, the benchmark was within the same company (Rolls-Royce). But other examples have studied the performance between companies. Michigan State University compared the Benchmarks have shown that the performance-based approach yielded significantly greater economic returns contracting practices of the US automotive manufacturers with those of their Japanese rivals, focusing on product recalls. It discovered that resolution lead-times varied by more than 500% because the Japanese approach drove collaboration, whereas the US approach guaranteed confrontation. Innovation is a topic of wide interest to executive management, yet contracting practices can often run counter to their intent. Risk allocation clauses such as liabilities and indemnities are frequently hard-fought. For the winner, their victory comes with a high price, as a study of the telecommunications industry illustrates. The major US and European telecoms providers typically push for onerous liability clauses, failing to realize that this 4 Pay For What You Get: Putting Performance-based Contracting To The Test Knowledge@Wharton, October 15 th, 2009 IACCM 2009. All rights reserved. Page 5
causes their suppliers to focus risky (i.e. innovative) products onto their less demanding Asian competitors. So economic value, cycle times, innovation all critical weapons in today s highly competitive global economy are directly influenced by the choice of contract terms. It is clearly time for a more strategic view of contracting policy and practice. Advocates for Change The General Counsel at one of the major US corporations recently told me that he always requires his staff to explain the economic cost of term and condition alternatives. Another senior executive described the tools his company uses to assist business units in identifying the right contractual relationship to match their goals. And a third expounded on the value that her organization has achieved from connecting their contract resources with product Contracting, along with leadership and organization, is one of the three fundamental competencies required to succeed in 21 st century business. development and lifecycle management. Through these strategic approaches, the companies concerned have reduced transactional focus and enabled greater efficiency and effectiveness in their contracting process. They offer terms that are appropriate to the desired relationship. This does not mean that negotiation frequency has increased in fact, the opposite is true. These organizations are selective about when they want to negotiate and then ensure that the topics for negotiation are productive. For agreements where there is no negotiation, they ensure that standard terms are appropriate to the desired outcome. 5 These isolated leaders are not alone in recognizing the need for change. In a recent paper 6, Professor Leslie Willcocks of the London School of Economics asserts that contracting, along with leadership and organization, is one of the three fundamental competencies required to succeed in 21 st century business. His views are supported by a growing chorus of commentators and managers who see the problems created by today s process and practices, which is limiting both performance and choice. 7 Indeed, even those who are 5 One key consideration is that the need to negotiate is determined by the potential value of the outcome on this particular occasion, rather than by a rigid view of the customer or supplier relationship category. Smart contracts may enable a variety of relationship types, operating under different terms related to risk/reward factors. 6 See Collaborating To Innovate Willcocks & Craig (July 2009) 7 For example, The Economist Big Is Back (August 2009) highlights the extent to which outsourcing has been frustrated by poor contracting. It is also reported that the US administration will in-source extensive activities because they lack the skills to manage outsourcing, even though this defies economic logic. IACCM 2009. All rights reserved. Page 6
charged with leading contracts and negotiations recognize that much of what they do leads to the wrong results, but feel they lack the empowerment to change things. 8 This frustration is shared by a growing number in the legal community, especially within major law firms. Figure 2 Development of Contracting Competence (from Willcocks & Craig, 2009) 9 A transition to strategic contracting is achieved only through executive support. It demands a new appreciation of the role of the contract and the resources associated with its creation and management. Since contract terms and policies are so diverse in their organizational ownership, significant change can occur only if like Lou Gerstner the CEO understands why it is important and mandates the change. 10 One route to change is of course that a top executive has a flash of inspiration, or becomes so frustrated that they demand improvement. But an alternative is for existing contract or legal resources to recognize that today s complex markets and enabling technologies have transformed the role and importance of contracting and to use case studies like those cited in this paper to prompt executive support for its improvement. 8 In the 2008 / 9 IACCM study of the most frequently negotiated terms, 75% of respondents acknowledged that today s focus for negotiation does not optimize business outcomes. They feel unable to change because of resistance by internal stakeholders and by the other side. 9 Step-change: Collaborating To Innovate, Professor Leslie Willcocks and Andrew Craig 10 It is however important that executives are clear about their goals and ensure a review process to monitor progress. Like many change initiatives, it otherwise risks being hijacked by political interest groups seeking to gain organizational control and status. Contracting competence requires collaborative and empowered resources, not large groups of specialists. IACCM 2009. All rights reserved. Page 7