This is article is about contract value leakage — how companies are losing serious money in their sale-side and procurement contracts, what can be done about this and how much the best in class gain profitability comparing to others.
Contract value leakage means the difference between the value expected from a contract and the value realized in its implementation during its lifetime.
Research by International Association for Contract & Commercial Management (IACCM) demonstrates that the best in class companies lose on average 6,2% of their annual revenue due to contract value leakage. For the rest, the average loss is 12.4%. For the sell-side, this means loss of revenue and for the procurement-side, loss of savings or value.
According to Tim Cummins, President of IACCM, a boost to bottom line figures can be achieved by focusing on an often neglected discipline: Contract Management. The main source of contract value leakage traces back to poor contract quality. Good contract development and management could improve profitability by the equivalent of a massive 9% of annual revenue.
The situation and impact is different in all companies but we all understand that it makes sense to try to stop the leaking, right?
So what is contract value leakage?
Main reasons for contract value leakage are poor contract quality, poor management of the contract and cost of contracting.
1. Quality of contracts
Contract might be unclear on what needs to be delivered for the price paid. An example of this are insufficient service descriptions, where you think you are buying something but the vendor is actually obligated to provide you less and (has the right?) to charge for the extra work.
If your template is not suitable for the purpose you are contracting for. You might, for example, end up using a supplier template to procure IT SW development project to realize that the vendor owns the IP for a software product you paid for.
2. Cost of contracting
Internal cost of contracting is often missing from project ROI calculations. Companies do track the external legal cost, that only represents a fraction of the total cost of contracting. An IACCM study indicates that even a low risk contract costs 6900$ even if you used only two hours of legal time. Best-in-class companies get their contracts done in half of the time, for half of the cost others incur.
3. Management of the contracts
For example, on the sell-side, you may have contracted a yearly price increase based on an index but never adjusted the price for the customer. On the buy-side, a supplier is constantly charging you extra for work that should be delivered based on the contracted fixed price. Neglecting contract management could also mean that you originally contracted for a higher amount of services than you are currently consuming but never asked for a price adjustment.
What should be done about this?
In simple terms, contract value leakage means that you are not getting the value that you are expect out of your contracts.
What can you do about this? Make better quality contracts, quicker and cheaper, then manage them properly. Easy, right?
1. Quality of contracts
To improve the quality of the contracts the main areas of focus should be 1. quality of templates and 2. how people use them.
Do we have good quality templates in place?
What is a good template?
Good template is clear on responsibilities, obligations and remedies. It specifies clearly what is included in the price and how the price is adjusted throughout the lifetime of the agreement.
It contains instructions on how to use the template and alternative clauses for the most commonly changed clauses (or a playbook). Terminology is consistent between body of the Agreement and in appendices, and there is consistency between templates as well.
Usually generic templates (like general terms and conditions) are not well suited for almost any cases and their usage should be limited only to minor agreements of non-significant value or risk.
Do people know how to use and negotiate with templates?
It is odd that many companies don’t have contract playbooks or contracting guidelines in place. Do we know what can be accepted without additional approvals from legal? What are the deal breaker clauses that we never accept? If the service description is not clear enough on what is provided with the price agreed it leads to contract value leakage, poor relationship and a lot of time spent on renegotiation of the scope of the agreement.
Outsourcing contracts are a great example where in many cases there is a big difference between what the provider thinks they have sold and what the customer thinks they have bought. Getting the deal approved on both sides requires sometimes quite a lot of juggling that leads to a gap between expectations and reality.
Another example of the scope increase is that there are things that have not been agreed at all, things like, who has overall responsibility for delivery milestones in a project where there is a third party implementation. Are liquidated damages agreed? Are SLA´s and remedies agreed? Many times the service descriptions are not specific enough.
2. Cost of Contracting
Legal and procurement resources are deemed to be the bottleneck in most organizations. So how do we ensure we use their time most efficiently and in the right cases? What can be “shifted right” for the business to negotiate on their own and how do we increase the throughput of legal and procurement, without losing quality? Many of the drivers for poor quality also drive higher contracting costs and poor management of the contracts, increasing the value leakage of contracts.
How efficient we actually are?
Here is some data provided by our friends at IACCM. Do you know how your company compares?
Contracting Costs and Cycle Times
|Transaction Cycle Time||11.5 days||21.2 days||46%|
|Cost of Completing Simple Contract||$3.800||$6.900||45%|
|Cost of Completing Medium Contract||$14.000||$23.000||39%|
|Cost of Completing Complex Contract||$49.000||$100.000+||51%|
By looking at these numbers more closely it shows that what we normally look at as contracting costs (use of external legal costs) represent only a fraction of the actual costs incurred by an organization. In this table the cost of completing simple contract the overall cost is 6900$ but it only assumes two hours of internal legal time. The actual big cost comes from work hours of all other personnel related to the contracting process. Contract managers, Security, Compliance subject matter experts, etc. This cost is often disregarded in the business case calculations of a project (as well as the RFP process cost).
Contracting costs can be reduced by 1. Creating better quality templates, 2. Building guidelines, 3. Implementing playbooks (including optional clauses) and 4. New technology. There are numerous IT solutions developed during the last few years to reduce contracting costs in areas like template creation, clause libraries, contract review, online negotiations, e-signing, collaboration etc. This is an area that is developing rapidly and is already at a maturity level that provides significant value. Legal and procurement seem to be the bottleneck in most organizations, so how do we ensure we use their time most efficiently and in the right cases. What can be “shifted right” for the business to negotiate on their own and how we increase the throughput of legal and procurement, without losing quality? Many of the drivers for poor quality also drive higher contracting cost and poor management of the contracts increasing value leakage of contracts.
3. Management of the contracts and relationships
Management of the contracts is neglected in many organizations. Most commonly seen problems relate to price and delivery against the agreed price set out in the contract.
Suppliers do not invoice according to the contract, e.g. they may not use the price escalation mechanisms allowed for in the contracts or make invoicing errors. On the other hand, the case may be that the seller charges for work that is included in the fixed price or simply does not deliver what the customer is paying for. In addition, charging for different kind of delivery fees and invoicing fees that are not agreed in a contract are commonplace.
Disagreements on the scope and price lead to poor customer experience and, thus, loss of renewal or business. According to IACCM, buyers may lose on average 20% of the value expected from a contract, 12% on hard leakage (e.g. invoicing errors and price adjustments) and 8% on soft leakage (eg. delivery failures, poor customer experience).
Another real life issue is that many times those who actually manage the supplier or approve the invoices might not be aware of what the supplier is supposed to deliver, or do not demand penalties for SLA breaches or other remedies that they have contracted for. Sometimes the source to contract value leakage may be due to difficulties in finding the contract from the company contract repository, not having access to the contracts, or that a contract might have a lot of amendments making the contract difficult to read and understand.
What are you going to do about contract value leakage?
Our hope is that we have been able to raise awareness of what contract value leakage is and have provided some food for thought, so that you can start doing something about this in your company. We are very happy to discuss this topic with you and offer help and assistance on the way.
Bryan Ball, Contract Management: How the Best-in-Class Maximize Their Potential (Aberdeen Group, July 2017); Tim Cummins, The Cost of a Contract (IACCM, November 20, 2017)
Tim Cummins, Poor Contract Management Costs Companies 9% — Bottom Line (IACCM, October 29, 2012);
Supporting Local Public Services Through Change, Contract Optimization (Ernst & Young 2016) at 2; KPMG:LLP Strategic Sourcing Point of View: Shared Services, Outsourcing Contracts Can Hinder Business Plans Without Proper Governance (Feb. 23, 2012).
Leak-Proofing Your Contracts Processes May 8, 2018 https://www.iaccm.com/resources/?id=10151