Procurement

Bad Contracts Cost Companies Good Money

Jun 21, 2013

How much do bad contracts cost? On average, it is 9.2 percent of annual revenue.

Lost money has consequences, not least of which is lower profitability. Losing money also means lost market share, less capital for investments, underperforming stock, and a major hit in profitability in businesses where margins are low.

Losing money as a result of bad contracts is also a factor in senior executives losing their jobs, noted Tim Cummins, president of the International Association for Contract and Commercial Management (IACCM).

Tim Cummins. Credit: IACCM

Tim Cummins. Credit: IACCM

Cummins discussed the benefits of improving contract negotiations last week at the ProcureCon conference in St. Louis. Yesterday, I discussed his views about developing contracts that treat both parties as equals, share risk, promote problem-solving relationships, include performance metrics for both sides, and stress continuous improvement. Here, I'll share his thoughts about what bad contracts cost in revenue and a company's ability to quantify the benefits they provide.

In detailing money lost by bad contracts, Cummins said IACCM surveys show oil, gas, and utility companies have the highest annual loss rates, 14.5 percent, followed by pharma and health at 10.7 percent. Manufacturing losses are 6 percent of revenue, IT and telecoms absorb 5.4 percent in losses, and services such as outsourcing and consulting post the least losses, at 4.8 percent.

"There are big gaps between these losses," he remarked. The losses indicate how much profitability can be claimed by rethinking the procedure for developing contracts. Many businesses he cited, for example, have problems in such areas as contract scope, performance failures due to over-commitment, inappropriate contract structures or responsibilities, failure to implement or include relevant terms, and weakness in contract change management.

The number-one cause of what goes wrong, Cummins added, is disagreement over contract scope. This indicates that negotiators must allow for changes in operations when necessary. "We fear scope change," Cummins said, "because we worry its cost will nickel and dime us." Yet IACCM data show that by not anticipating and allowing for change, the eventual cost of problems will be much greater.

Credit: supakitmod at FreeDigitalPhotos.net

Credit: supakitmod at FreeDigitalPhotos.net

Bad contracts reflect corporate culture. The job of procurement, he said, in some companies is so specialized that simplification has been replaced by complex language and requirements that satisfy lawyers but do not provide productive agreements for either the buying or supplier. "We find 60 different job titles within the procurement family," Cummins said. "Are they different, or just confusing?"

Ingrained supply management practices, he continued, "are an obstacle to getting the right suppliers or achieving innovation." Moreover, contracts, as typically written, are not only counterintuitive to advancing the strategic interests of both parties, they rarely give each side a way to measure their benefits, or lack thereof.

"Few companies know what proportion of their contracts generates benefits," Cummins remarked. Being able to figure this out "is a big opportunity" to improve what a contract should deliver in revenue potential and buyer-supplier relations.

In discussing IACCM cases, Cummins cited one large sell-side company where 29 percent of its contracts were underperforming. Implementing changes to identify these problems and correct them would produce a 2 percent increase in bottom-line revenue, he estimated -- which for the company in question equates to $500 million.

Another company had a 4.2 percent average reduction in margins due to poorly drawn contracts. Since the company typically operates on only a 2- to 3-percent average margin, resolving problems with bad contracts would have a meaningful impact on profitability and "probably save the CEO's job," Cummins said.

One oil and gas company experienced 26 percent cost overruns that IACCM attributes to weaknesses stemming from incomplete or nonexistent contract scopes. Construction work also began before a contract was finalized, there were misalignments between requirements and supplier capabilities and competence, and, not to mention, there was a failure to adequately prepare bid-evaluation criteria as they applied to contract terms.

"Our work finds that 70 percent of troubled projects results from commercial issues rather than technical issues," Cummins said. Yet in almost every case, a buyer's response perpetuates the existing problems. "We react by reinforcing efforts toward more penal terms, which builds negativity. This needs to change."

Next, I will look at recommendations Cummins makes for developing viable contracts that promote the goals and profitability of both buyers and suppliers.