Loading...
 
IACCM - International Association for Contract & Commercial Management Contracting Excellence Magazine
 

Contracting Excellence Magazine - Dec 2008

 
 

 

 


 

 

 


 

In tough economic times, contracting excellence offers relief

 
IACCM research into contracting practices shows that a more holistic approach, including more flexible rules, improved collaboration with other functional groups at an early stage, and the automation of processes, can produce enhanced financial results TIM CUMMINS, IACCM
 
 
By Tim Cummins, IACCM

Poor contracting costs you money

A friend of mine is convinced that any company could raise its profitability by at least 10% simply through better understanding the link between contracts and economics. Recent studies suggest that he is right — they show companies that have focused on “contracting competence” achieve 7–10% margin improvement through a combination of reduced costs and higher revenues.

I believe most companies have lost sight of the purpose of contracts and have allowed the process through which they are made and managed to be hijacked by special interest groups. These groups are often more interested in protecting their power and status than in driving successful business results. Indeed, many of them depend on constant crises and problems to justify their headcount. The world of contracting and contract management is bedeviled by a “hero culture” of snatching victory from the jaws of defeat and of spending countless hours negotiating protection against phantom risks.


Opportunities for improvement

Contracting policies and practices at most companies are resulting in lost revenue and profit. Few organizations have successfully established a link between their contracts and their financial performance. As a result, they have limited insight to the opportunities that are being missed or the trading relationships that are being mismanaged. The reasons for this are that there is typically no one accountable for contract outcomes and “the process” is frequently a series of disjointed activities with unclear or competing ownership.

These conclusions come from extensive research and benchmarking by IACCM. They are supported by a wide range of case studies from both IACCM and academia, revealing that most contracting processes are driven by narrow perspectives of risk. These perspectives result in terms and conditions that protect against certain types of risk — but take no account of the counter-risks that they generate. The current collapse in financial services is the most recent — and vivid — example of this failure in contract governance.

But there are many other examples that are allowed to operate unseen and unchallenged. Take the story we highlighted in the IACCM News Highlights earlier this year from the telecoms industry, where onerous liabilities clauses are frequently imposed on suppliers by their large telecoms customers. Our research tracked the impact of those clauses as they travelled through the supply chain — and discovered that as a result, US corporations are frequently not offered the most innovative product by their suppliers. Instead, their emerging competitors in Asia were the first to benefit from innovation — since these companies were far more balanced in their approach to risk. Was this loss of innovative product really the smart economic choice for those US corporations?

Analysis of contracting experience also offers remarkable insights. For example, one major corporation undertook an extensive review of lost contracts and discovered that there was an inverse relationship between low prices and win rates. Dropping price was not the answer to winning business; sales teams needed training on selling value.

Yet another example shows how terms and conditions drive behaviour. It is easy to understand how liquidated damages clauses are directly linked to a loss of openness and collaboration. As a result, far from protecting against risk, they create risk. Academic research identified alternative approaches that encourage pro-active sharing of information and enable the parties to mitigate risks and cut costs.

Finally, to what extent are rigid policies and rules resulting in a loss of trading opportunities and diverting negotiators’ attention away from the topics that could generate increased value? As a result of a recent IACCM study of indemnities clauses with a large corporate member, multi-million dollar savings with no incremental risk were achieved simply by establishing a new set of more flexible rules.

All the evidence suggests that most companies could gain from improved collaboration with key trading partners, yet neither side currently grasps how to make the breakthrough to true “win-win” relationships on a consistent basis. At this time of economic distress, most companies could benefit from undertaking a thorough re-evaluation of their contracting process and the standard terms, policies and principles that underpin their trading relationships. Contracts form a framework — a set of rules — under which relationships are managed. If they establish the wrong framework, they will result in lost opportunities.

Why do we have contracts?

The purpose of a contract is to establish and safeguard economic interests. While the ultimate protection of those interests may be a resort to law, the reasons for having a contract are not exclusively legal. Indeed, our networked world and the shift to a services-oriented economy have arguably reduced the importance of many traditional legal imperatives, while increasing the significance of others.

An effective contracting process — from which the contract is an output — ensures a mutuality of understanding between the parties involved. The “contract” is a formalised approach that provides a record of key expectations and obligations to guide performance, and consequences in the event of failure by one or both parties.

“Contracting excellence” expands on these basics, by selectively creating a forum in which the parties can optimise the value of their relationship, both at inception and over time. This means that economic interests are not only protected, but enhanced. To achieve this greater value, the parties must commit themselves to a wider and more open appraisal of their respective needs and capabilities; and they must also embed ongoing review and change mechanisms to ensure a response to shifting needs or opportunities. In this context, “negotiation” is not a temporary phase of the process, but an ongoing dialogue through which alignment of interests is maintained.

This distinction between a basic form of contract and a more advanced form of contracting is important. The basic contract is appropriate for relatively short-term transactions. The process-based view is important when the parties seek to establish a life-cycle or longer term relationship during which needs and sources of value are likely to change.

While most contracts today reflect a balance of legal and financial views, a majority fail to support optimised economic outcomes. The financial aspects of contracting are frequently restricted to basic considerations of setting prices or charges, payment dates and determining liabilities when things go wrong.

Best practice contracting ensures that the terms associated with a product or service are set in a way to generate economic benefit to both parties. They understand the value impacts of different relationship structures and the individual terms that support those structures. “Financial engineering” is a source of competitive difference.

Best practice also ensures that economic interests and value remain aligned during the execution of the contract or relationship — and that misalignments are addressed rather than ignored or allowed to fester.

Achieving improved results

It seems self-evident that companies and organisations would want to achieve these goals, so what goes wrong? Why don’t contracts typically support these positive attributes?

One key reason seems to be the lack of empathy between “the business people” and those who see their role as “protecting” the business from the excesses of those people. The contract — and the contracting process — have come to be seen primarily as an instrument of control and compliance. Its creative value has been lost or overlooked. For many “business people”, the need to go through the contracting process is an unfortunate requirement and they avoid it for as long as possible, offering the internal “forces of protection” minimum time and exposure.

The result of this is that those responsible for contracting frequently feel frustrated — they are involved too late; this limits the potential value or innovation they can offer, and they frequently spend their time unwinding ill-considered commitments, rather than providing creative solutions. On the other hand, they often do not help themselves because they remain involved in far too many low-value activities, resisting automation and empowerment that can drive business efficiency and reduce cycle times.

From an economic perspective, the re-assessment and re-engineering of contracts and the contracting process is long overdue. Without the right forms of automation and without the right measurements and accountability, it will continue to frustrate the business rather than become a source of economic value and competitive differentiation. Contracting is a process, not a series of disconnected activities. And as a process, it demands a more holistic overview of the results that are being generated. Today’s fragmentation — and the influence of competing risk specialists — results in no meaningful accountability. Whatever goes wrong with contracts today, you can be certain that it is no one’s fault!

How can IACCM help?

In addition to case studies and examples, IACCM has developed a number of practical and low cost tools to support companies wishing to drive improved performance. These include our Capability Maturity Assessment, which provides rapid benchmarking of current process performance, and our “Cost of Contracting” workshops, which offer a practical and pragmatic method of developing a high-performing contracting process.

IACCM delivers support through its own skilled practitioners, or in partnership with appropriately qualified consultants and service providers. For more information on any of these offerings, contact swatson@iaccm.com or kkawamoto@iaccm.com.

 
Tim Cummins,
CEO, IACCM
 
 

 


 

 

 

 


 

Moments of risk

 
Understanding the five core elements or ‘moments’ of risk, is essential to a culture that maintains a healthy balance between risk and opportunity. JACQUI CRAWFORD, Rolls Royce
 
 

By Jacqui Crawford, Rolls Royce

Corporate greed caused the collapse of the global banking system and all the fables came true. No one believed that disaster was imminent, the sky fell and the goose that laid the golden egg died.

Oops!

What shall we do? I know, shall we round up everybody with an insatiable hunger for power, authority, fame and wealth and eliminate greed? The call in the press for corporate morality grabs headlines but misses the point by miles. Greed is a natural human characteristic and, balanced with prudence and a framework of sensible behaviour, creates a condition for personal and dynamic competition that in turn created the free economy and a globally integrated commercial enterprise.

Greed was just the spark; the tinder was bad risk management and unchecked behaviour that allowed the situation to spiral far beyond the moment that practical intervention would have been useful. Nobody wanted to hear that the sky could fall and governance is boring.

Until the crash, in the UK, Gordon Brown was the very boring and off-trend prime minister mired by daily calls for his head. Suddenly, boring and prudent is very cool and it would appear that Brown is the new Black!

Will his intervention and prudence stop panic in the market, deliver stability and restore us to calm and confidence? What can the globally connected professional commercial community learn from this crisis?

The key to global commercial enterprise risk management is not in having a regulatory system to shuffle risk; every corporation in the global economy has this already. The key is a culture that is supportive of risk evaluation and maintains constant attention on the variables that affect the value proposition, and a laser-like focus on the moment at which exploitation of liabilities for a given return are beyond pragmatic intervention.

Bad risk is realised when optimism smothers prudence — caused by ignorance of the events that erode value and a decision to travel in the hope of ignoring the storm warnings in the wind. 

Good ideas flounder when prudence and fear smothers optimism — great ideas are lost when no one is brave enough to give up what they have in order to pursue a prospect they believe is worth the risk.

Five core “moments of risk”

Understanding the five core ‘Moments of risk’ will be essential in establishing a culture that maintains a healthy balance between risk and opportunity:-

1. Ground rules

Regulate multiple transactions and never be any more than two simple moments or transactions away from the asset or underlying value proposition. Internal governance of programs and deals must be high profile, impartial and separated from the owner of profit and loss accountability. External governance is frequent and mandatory where private individuals hold assets secured on debt traded by the company.

2. Risk patterns

Know where the risks began and how to follow the pattern of risk as further interventions occur. Constantly supervise high profile risks at board level and maintain a living corporate risk register that is open to audit. Accrue for risks up to the moment and that have a high likelihood of poor outturn where the risk is still worth the opportunity. Always measure risk with opportunity.

3. Event Awareness

Be aware of multiple moments that can create an interdependent event chain that will create new conditions — and new risks and opportunities. Invest in Monte Carlo simulations to understand the impact of events. Create standard conditions so that the pressures caused by events moving in and out are reversible if caught in time.

4. Trigger moments

This is the moment when a risk moves from a stable controllable form into a new potentially uncertain or uncontrollable form post event, potentially in force majeure conditions. The key here is not to manage the event or multiple events as these can be random; but to find the point at which your intervention is useless. Viruses lurk in all complex event chains and will kill a deal if allowed to replicate unattended.

5. Stop signs

This is the toughest moment of all. Motivations of the internal stakeholders and external parties may be at variance, and the landscape unclear. The risk profile may have shifted for one party and the balance of risk and opportunity is no longer equitable. Taking stock is more prudent than perpetual motion. This is the moment of leadership choices.
While world economies settle into the new era of moderation after a moment of madness, prudence is not the answer; to err is human and risk, if treated with respect, can be good for business.
 
Jacqui Crawford,
VP, Commercial Solutions,
Rolls-Royce plc,
Email: jacqui.crawford@rolls-royce.com
Board Director and Vice Chair, Europe; International Association for Contract and Commercial Management (IACCM),

About the author

At Rolls-Royce, Jacqui leads the creation and development of commercial strategy and infrastructure for new products and services in key market segments, integration of capability across teams and effective deployment of commercial resource across the civil aerospace business. 

 
 

 


 

Managing the financial cost of exception to contracting standards

 
The growth in contracting standardization creates the risk of too much control and too little flexibility. This article analyses the steps involved in managing exceptions to standards in a cost efficient way, and reducing to a minimum the need for exceptions at all. ASSOCIATE PROFESSOR RENE FRANZ HENSCHEL, University of Aarhus
 
 

By Associate Professor Rene Franz Henschel, University of Aarhus

Main points

• In managing the financial cost of exceptions to contracting standards, the first step is to put up an intelligent contract standards monitoring system.
• The next step is to maintain tailor-made, fair and transparent contracting standards.
• The third step is to eliminate unnecessary information and repetitiveness in contracting standards.
• The fourth step is to enable your organization and the customers or suppliers to handle the necessary exceptions themselves.
• Finally, where available, you should consider the use of independent contracting standards and the elimination of your own standards as a tool in managing the cost of exceptions to contracting standards.

Contracting must support the business transaction in the best possible way. Unnecessary time, costs and risks must be avoided. The customer must have a quality experience. One way of doing this is to use contracting standards. The sequence of activities — negotiations, contract formation, performance, change management, renewal and so on — is therefore subject to standardization by most companies today.

A typical example could be that when ordering a product or service, the customer must contact the sales department (for example, online portal or by phone), only discuss and negotiate the most important terms (price, specifications, quantity, delivery and payment), accept the standard conditions of sale (for example, click-accept, electronic signature or by letter), and then await delivery. By using contracting standards, the company can improve and control the contracting process, secure the contracting quality and reduce the need for individual negotiations to a minimum, saving time and money. Furthermore, the use of contracting standards reflects the commercial needs of the user, for example, the seller selling standard products online and using liability disclaimers in standard forms, or the buyer using standard termination and other clauses.

However, if the contracting standards are unclear, unnecessary, inflexible or in other ways do not fit the situation or the satisfaction of the other party, negotiations have to be conducted, meaning more time and cost — if the business is not lost already! Furthermore, during the negotiations, the company faces the risk of changed circumstances and competition from others, tempting the customer or supplier not to close the deal. This risk has to be minimized. Therefore, it is crucial to optimize contracting standards and reduce the need for exceptions to a minimum. Furthermore, if exceptions are needed, they have to be managed in the most cost-efficient way. But how should a company best manage the financial cost so exceptions to their contracting standards are reduced to a minimum, and the necessary exceptions handled most efficiently?

Cost-efficient handling of exceptions to standards

Create an intelligent contracting standards monitoring system

Many companies do not have systems that enable the contracting process to be monitored. In order to conduct a thorough analysis of the financial cost of managing contracting standards and exceptions, you have to know your contracting history.

· How many of your customers ask for individual negotiation of standards? Is it high-, medium- or low-volume customers? 
· Which clauses or processes are contested and why? How long do these negotiations take? 
· What are the financial costs of handling these exceptions or irregularities? 
· Is the cost in handling exceptions balanced by the profits from more happy customers? 

Only if the relevant data are collected and analysed, you can create the necessary contracting intelligence. Therefore, the first step in managing your financial cost is to create the systems that support the necessary visibility into the time and costs of managing exceptions to contracting standards, in order to create the solutions that are needed to optimize your processes and tools.

Maintain tailor-made, fair and transparent contracting standards

The first issue to consider when faced with a customer that does not accept your contracting standard is to consider the design, fairness and transparency of your contracting standard. There could be a very good reason why the customer does not accept your standard at first glance. The first question to ask is whether your standard is really understood by the other party. In many cases, the other party contacts you in order to get clarifications of the language, the contracting process or the actual legal implications of your standard. This is especially true in cross-border transactions. The solution to this problem should be to improve the language of the standard and to explain its contracting process and the legal implications more clearly. Apart from ensuring that people in the organization who deal directly with your customers or suppliers are able to answer such questions, you might want to refer your customers or suppliers to online “Frequently asked questions” for such things as diagrams about the contracting process in order to reduce the time and cost of having to answer the same questions over and over, and to create trust and transparency in your contracting processes.

Even if your standard is clear and transparent, the second question is whether you have the right standard for the transaction in question. Standards are often implemented based on a “copy-paste” basis from other parts of the organization, and based on years of (outdated) company practice or standard templates from service providers with limited or no knowledge of the particular transaction in question. Recurrent objections to the same standard should mean that you seriously consider whether it fits the particular type of transaction.

A frequent criticism is the use of over-protective standard terms. As the supplier, is excluding all liability towards your customer justifiable? As the customer, is the claim for unlimited liability of the supplier or service provider fair and just? In this context, you should conduct a thorough risk-analysis, as the courts can set aside unreasonable or unconscionable clauses. If this happens, the background law applies, with the result that time is wasted and relationships and financial outcomes may be adversely affected. Therefore, ask critical questions as to the need and fairness of individual clauses or processes that are (too) often contested by your customers or suppliers. Striking the right balance between good customer relations, cost reduction and managing your legal risk is the ultimate goal.

Eliminate unnecessary information and repetition in contracting standards

You should always strive to eliminate redundant processes and tools and let the business flourish! One way is to adjust the amount of information to you give — if you give too little information, your customer will contact you to get the necessary information, and if you give too much information, you risk opening up a flood of discussions on points that are not relevant for the majority of your transactions.

Many standard conditions contain clauses which would apply according to the applicable background law anyway even if not mentioned in the standard; for example, particular kinds of losses mentioned in a limitation of liability clause or clauses on mitigation of damages. If this particular legal result goes without saying, why bother mentioning it in the contract? This puts the focus on the amount of information that a contract needs. In modern contracting standards companies focus on trimming the contracts and reducing the amount of information to what is absolutely necessary — and nothing more! The result is that the amount of information can be reduced by 25–50% without increasing the risk, but with the advantage of saving time and money, and at the same time improving customer satisfaction. We all know how often the 2nd edition of most books don’t have less pages — on the contrary, there seems to be a law requiring more complexity and information for each new edition published. I urge contract professionals to question this tendency in their contracting — ease of business does not mean uncritically increasing the amount of information given each time you create a new standard.

If you conduct a thorough analysis of these issues, you might also find that you actually accept certain changes to your own standards more frequently. One striking example is the use of limitation of liability clauses — always leading the IACCM Top 10 lists of most negotiated terms (see http://www.iaccm.com/articles/2008top10/)! Why play this game over and over again? Your own exception to the standard could actually be the standard, and not the exception! Change the standards accordingly, and save time and money and the risk of somebody else getting the deal.

Even if you are able to cut down on the information you give; for example, in your contract, you should not forget to secure the relevant processes and information for post-award contract management. One example is how you handle claims or change-management. If you cut down the text and processes on these topics, you might end up losing more time and money in post-award management. Therefore, you have to strike the right balance between pre-award and post-award considerations of contracting standards, as they may sometimes counteract each other.

Enable your organization and the customers or suppliers to handle the necessary exceptions themselves

If the analysis shows that the exceptions can or must be negotiated according to circumstances (for example, according to customer profile, governing law, price, quality or service levels) consider managing the exceptions intelligently and cost-efficiently.

The first step should be to map the particular pre-approved fall-back positions and systematize the tactics for presenting alternatives in the contracting process.

The next step should be to design the most optimal and cost-efficient process for handling the exceptions. Too often, companies build up slow and cost-inefficient processes where legal has to see each and every exception that procurement or sales has on their desks. Why not enable others in the organisation to handle this? You may still want to keep certain important exceptions for approval by legal, (for example, “code red”); while letting others in the organisation (for example, sales or procurement) handle the rest on their own (pre-approved “code green” clauses); and create a fast-track approval system for the ones that can be cleared relatively fast (“code yellow”).

If you create this system, and agree that it’s a good idea to enable others, why not consider enabling the customer or the supplier to handle the pre-approved exception themselves? One way of doing this could be to present the different alternatives to your customer or supplier, enabling them to choose how to construct the standards according to their individual preferences and circumstances. If this process is automated, you will save even more time and cost — and create that “feel-good” experience of staff having ownership of the terms and conditions of the transaction. If this is combined with the above-mentioned issues — improving language and reducing the length of the contract — it dramatically reduces the contracting workloads and cycle times in your organization. This solution has been successfully implemented in some major companies. You should, however, be careful to design the relevant standards and exceptions in order not to confuse the customer or supplier, and to minimize the time (and cost) explaining their benefits.

Consider the use of independent contracting standards and eliminating your own standards

If you have conducted the above-mentioned analysis and perhaps decided you can reduce the workload, cycle time and cost to your organization, as well as to your customers and suppliers, you should consider the relevance of keeping your own contracting standards at all. This is a very provocative suggestion, but it will eliminate the argument about which standards to keep and which to eliminate. If you have partners with whom you never have problems, why not consider reducing the contracting standard to a minimum; for example, by connecting the back-offices of your organization and your partners — reducing contracting to a mere order. (See also, Craig Guarante, “Improving the partner experience through policy, process and automation”, Contracting Excellence, Vol. 2.1, October/November 2008). This will create visibility and transparency over cash flows and other important issues, and might reduce the need for certain contractual standards, such as payment clauses.

Furthermore, you should consider if independent contracting standards could form the basis for a compromise and reduce the time for negotiations and possible threats of a deadlock; for example, by using standards prepared by associations like the International Chamber of Commerce (ICC) or the International Federation of Consulting Engineers (FIDIC). The purpose of these general conditions is to lay down a balanced set of rules based on the practices that have developed within an industry, so the parties can agree on the basic terms of their contract by a single reference to the general conditions. The individual negotiation of terms is thereby reduced to a minimum, saving time and money. Similarly, neither party risks losing face by having to accept the terms of the other party. These advantages are particularly evident when considering clauses that are subject to intensive negotiations, such as limitation or exculpatory clauses. However, you always need to consider whether these independent standards are appropriate before you decide to eliminate or supplement your own standards.

Conclusion

The growth in contracting standardization creates the risk of too much control, to much formality and too little flexibility in the approach to contracting — and, therefore, also in the approach to managing exceptions to the contracting standards. This creates the need to optimize the handling of the exceptions to the standards so as to save time, money and, at the same time, manage the risks properly.

The first step in improving the financial cost of exceptions to the standard is to create a system to monitor and analyse the patterns and reasons for exceptions to the standards and the costs that follow.

Second, analyse whether your standards are transparent and fair towards your partner, and whether they are tailored to the particular transaction in question. Furthermore, it is necessary to eliminate unnecessary information and processes in contracting.

Third, when handling only the necessary exceptions, consider enabling not only your organization, but also your customers and suppliers to deal with the exceptions themselves. This is “ease of doing business”.

Finally, consider the role that independent contracting standards, and the elimination of your own standards, could play in improving the financial management of exceptions to your contracting standards.

Associate Professor René Franz Henschel, Ph.D.,
Aarhus School of Business,
University of Aarhus,
Email: rfh@asb.dk,
http://www.lib.hha.dk/staff.aspx?pid=11405.

About the author

René Franz Henschel is Associate Professor in Business Law at the Centre for International Business Law, Aarhus School of Business, University of Aarhus, Denmark. Before joining the research community, he worked as a Head of Section at the Danish Ministry of Economic and Business Affairs (1997-1999).

He is author of several articles and books on commercial law and contract management, including The International Contract Manual (chapters on Limitation of Liability and Liquidated Damages and Penalty Provisions, Thomson West, 2008) and Conformity of Goods in International Sales (Thomson, 2005). He is co-editor of the Nordic Journal of Commercial Law and of a number of online databases, including www.unilex.info on the CISG and the UNIDROIT Principles.
His consulting company, Henschel Contract Management, specializes in trimming and optimizing contract management from both an economic and legal point of view. www.henschel.dk
 
 

 


 

 

 


 

From industrial service providers to performance partners - no more services for free

 
How can manufacturing companies evaluate and price its services and performance, particularly when they have habitually been an unpaid part of deal? This article discusses the culture shifts and steps required to price services and performance so they are adequate to service provider and acceptable to the customer. KATRI REKOLA, Rekola Design Oy
 
 

By Katri Rekola, Rekola Design Oy

Main Points

• It is a good idea for manufacturing companies to identify “free services” and address pricing issues proactively.
• Starting to charge for services may require changing the sales culture and addressing issues like sales compensation schemes to include service sales.
• Pricing services is more problematic than pricing manufactured products — because services are intangible, their ownership is not transferred, and service quality is mostly “experienced”.
• The shift from selling equipment to selling performance is challenging.
• Selling performance makes it necessary to understand the customer’s business and even the customer’s customers — and involves more risks than traditional equipment sales.
• Effective performance indicators, and measurement and monitoring tools are essential for success.
• Performance partnering is not for everybody.

Traditionally, manufacturing companies have offered product support services, such as maintenance, without considering them a serious source for revenue or profit, but now they are focusing on enhancing their offerings by attaching increasingly more complicated services to their products. In addition to selling equipment, manufacturers are taking over part of the customer’s process, or even becoming responsible for creating value for the customer’s customers. We talk about full service, performance partnering, and value partnering. These rapid and fundamental changes in the manufacturing industry entail new challenges, especially in the case of selling performance.

Surprisingly enough, one of the biggest challenges with service pricing is to avoid giving services away for free. Traditional manufacturing companies often fail to see the value their service creates for the customer. When this value is clearly understood, the price can be aligned with increases in productivity. However, this is easier said than done; the big question is how to evaluate the impact of the service. Another challenge may be changing the prevailing sales culture. The sales people may be used to throwing in services to close the deal — and the customers may be used to free add-on services.

Failing to set the price at a level that is acceptable to both parties can lead to bitter misunderstandings and a short-lived relationship, ending in a dispute. Aligning expectations and promises with the actual service — and the contract — is essential. Properly defining the scope of work and agreeing on metrics and inspections can also help to avoid problems. Compensation for services has to be both adequate to the service provider and acceptable to the customer, since the customer’s success ultimately benefits the service provider as well.

From maintenance services to performance partnering

The following gives an overview of typical customer segments of the service offering of industrial business-to-business service providers, using maintenance as an example.

1. Basic
— focus on price;
— no long-term contract or relationship with the original equipment manufacturer, transaction-based contracts or purchase orders only;
— maintenance and spare parts.
2. Extended basic
— same as basic except based on a long-term service contract or own maintenance department supported by the original equipment manufacturer;
— technical support.
3. Availability (full service)
— focus on preventive maintenance, RCM (reliability centered maintenance);
— based on a service contract;
— maintenance, spare parts, training, inspections.
4. Performance partnering
— focus on OEE (overall equipment efficiency), how to make the most of the equipment;
— based on a long-term service contract;
— maintenance, spare parts, training, consulting, inspections.
5. Value partnering
— focus on the customer’s business process, not maintenance;
— based on a contract and long-term, intimate service relationship;
— same as performance partnering plus business consulting (possibly only remotely connected to the equipment).

In categories 3 to 5, maintenance is outsourced to the equipment manufacturer, but the relationship is not just about maintenance, especially for the 5th category. Currently, the 3rd category is the largest service customer segment of European equipment manufacturers, and there is a distinct trend to move customers from the basic segments to this group. Performance and value partnering (4th and 5th categories) is rarer; usually equipment manufacturers have some performance partners, but only a few value partners (maybe up to 10% of customers). It should be noted that although value partnering may sound extremely lucrative, it is not for all service providers. A value partner relationship involves complicated contractual issues — even more so than with performance partnering.

Traditionally, the customer buys, owns, operates and maintains equipment used in production systems. Alternatively, the customer can buy the performance instead of the physical product. In such cases, the manufacturer is responsible for operating, maintaining, and supporting the product (in addition to designing and making it). Thus, the long-term profit for both user and manufacturer will depend on the product’s designed-in life cycle costs, RAMS (reliability, availability, maintainability, and supportability) characteristics, as well as on the effectiveness and efficiency of the product exploitation and support processes.1

Consequently, the customer and manufacturer may have a business-to-business relationship lasting throughout the life of the product. The relationship is based on the product’s weaknesses (since services are mostly needed to prevent breakdowns or to fix equipment); and the manufacturer’s and customer’s capabilities and expertise, operation and maintenance strategies and infrastructure and so on. The relationship is as much based on intangible knowledge and expertise as on tangible physical components (such as spare parts, repair tools and documentation). Therefore, it can be characterized as a service process, where the service delivery strategy is dependent on a negotiated agreement.2

In the performance partnering scenario (4th category), the manufacturer will not profit from after-sales support services as such. Rather, product support will become a cost and a liability for the manufacturer. Actually, many manufacturers feel it is adequate to be as good as the competition, and have problems in seeing what there is to gain from making the product more reliable and easier to maintain. The predominant belief is that it will cost more and take more time to design a product for high reliability and low maintenance costs.3 To create a win-win situation for both the customer and manufacturer, the focus has to be on how to optimize the value chain for maximum competitive impact, and how to create additional value for the end-customer.4

The skills and competence needed to purchase or sell performance differ from those needed to sell basic maintenance or equipment. Collaboration between the different sales teams is required, as it is between product development and service development teams, especially since maintenance services do not exist in a bubble separate from the equipment. An understanding of both types of offering is essential, especially when selling full service, let alone when negotiating for performance or value partnering. When the focus shifts from equipment to optimizing the customer’s processes and maximizing value to the customer’s customers, a much broader understanding and expertise is necessary to reach an agreement that will be beneficial to all parties.

Trust and risk issues become more relevant in service relationships based on performance partnering, and especially value partnering, which means an even more intimate relationship between the service provider and the customer. Some companies are understandably reluctant to trust their service provider with the success of their core business or reveal their strategic goals and innermost processes, as a successful value partnership would inevitably force them to do — at least to some extent. On the other hand, from the service provider’s point of view, guaranteeing an outcome or agreeing on the availability or performance of the equipment can lead to tragic consequences if the situation — including pricing the service — is not handled with the utmost care.

Service pricing

The issue of pricing services raises several questions.5

• Should services be charged for in the first place?

• Should prices simply cover costs or should they also generate a margin?

• What charging methods should be applied? Should it be as part of a package also comprising other services or products, or separately?

Obviously, customers will resist paying for services they are used to getting for free, and will often expect some support services to be automatically included, especially in the case of IT systems. But when new services are added to the offering, it is also possible to introduce a new “charging for services” culture.

Compared to manufactured products, charging for services is especially challenging, because:

• ownership is not transferred (except in the case of equipment connected to the service);
• services are invisible and intangible; and
• service quality consists mostly of experience or credence qualities.

Industrial customers usually evaluate the value offered in a service rather than its price alone. Rather than focusing on the price and functional properties of individual services, the full service offer should integrate a value proposition related to improved equipment/plant/production line performance and reduced costs.6 The big question is how to measure the value, or the influence on profit, of the service when pricing is based on these elements. Another important issue is that service terminology can be imprecise and ambiguous. Language usage can vary, even within one company or team, depending on the participants’ professional background and other factors. If it is not clear what a “complete overhaul” (or “full service”) means, how can such service be priced or properly delivered? How can the parties have a common understanding of what is included and what is not? Even simple expressions such as “installation”, “supervision” or “monitoring” can create problems if their scope has not been defined.

How can a company actually make money on services? Before attaching a price tag to a service it is necessary to consider different ways to generate revenue and make a profit.

Revenue generation models

The revenue generation models of most industrial services can be based on one or a combination of the following five models.7

• Direct revenue generation: the customer uses the service of the service provider and pays according to use or planned use.
• Revenue generation based on a promise: the customer pays for the possibility to use the services of a service provider.
• Indirect revenue generation: The customer uses the service, but does not pay anything, or only pays part of the actual cost. The customer owns or has possession of related equipment, and needs to purchase parts or materials from the company at a price that also covers the cost of the service. (This may present problems in some markets, since, for example, agreements may prohibit or restrict end users from obtaining spare parts directly from the spare part manufacturer may be prohibited).
• Revenue generation based on value: The customer pays for the value provided by the service, but is not required to pay until payments from the customer’s customers have been received, or other benefits, such as savings have been realized.
• Participative revenue generation: The customer pays for information received when using the service.

Pricing models

Several pricing or charging models can be applied depending on the nature of the service.

• Value pricing: setting the price based on the estimated value the service gives the customer.
• Hourly rate pricing: a set price per an hour of work.
• Contingency pricing: setting the price after the service encounter based on actual costs incurred or the “realized” value to the customer.
• Cost pricing: setting the price based on costs incurred and
resources used.
• Volume pricing: setting the price based on how much / how many service products the customer buys.

Most customers prefer to know what they are paying for and how much it will cost them before making the decision to buy a product or service. When selling expertise it is not always possible to estimate beforehand the final cost — or the amount of work required — but it is usually possible to at least give an estimate. There can always be extra options for the customer to choose from, or checkpoints during the service process when changes can be agreed, allowing the customer to decide about the future of the service relationship. Another option is for the customer to state how much it’s willing to spend (a ”not-to-exceed” agreed price) — for example, commissioning the design of a tool and accepting the best design that can be achieved that cost.

Factors to consider
when pricing services

The following factors should be considered when pricing services:
• image: company image, intended price image;
• demand: amount of potential demand for the service;
• customer profile: how much customers are willing/able to pay;
• competition: how much competition there is, competitors’ prices;
• costs: actual costs incurred and resources needed;
• price strategy: aiming for volume or skimming the cream;
• business strategy: the goals of the company;
• taxes and imposts: additional costs
• regulatory and legislative requirements: such as competition/antitrust laws

To say that nothing good comes cheap is often true about knowledge-intensive business services. If the price is too low, customers suspect that they are not getting much expertise. If the price is inconsistent with your market or brand image, it may damage other areas of the company’s business. The trick is to achieve the right balance by considering the desired or actual image, the demand, the customer profile, and competition.

The more complex the service, the more the emphasis needs to be put on the value offered and other aspects such as the reliability of the service provider, rather than the price alone. Basic maintenance customers base their selection of a provider mostly on price, but full service customers evaluate the impact on plant performance, operating costs and so on. In the case of performance or value partnering, the issue of price gets even more challenging — including how to measure the value provided, which metrics to use, and how to ensure a win-win situation for both parties. It is not enough for the service provider or the original equipment manufacturer to know the equipment they manufacture can be optimally operated and maintained — a good understanding of the customer’s business and the market for the customer’s offering is also essential. For example, consider the situation where a company is only being paid by the customer for outputs. What would happen if the customer’s offering lost its market due to the entrance of an innovative competing product after the manufacturer had invested heavily in installing and running the plant as a performance service, only getting paid based on output? 

Where possible, setting a fixed price will enable the customer to:

· get a clear idea about what they are paying for; 
· be told what is included in the price before buying the service; and
· understand the total price (for example, airplane ticket = Ä1, additional charges = Ä15, taxes
= Ä47).

A clear, fixed price also makes it harder for the customer to bargain 

Measuring and
monitoring services

Performance measurement and monitoring are required by the customer and service provider:

• the customer needs to ensure that the service provider has the capacity to perform, and actually delivers what it has agreed to; and 
• the service provider needs to control and optimize the service delivery process, determine whether the customer is satisfied with the service, and secure predictable, measurable outcomes. 

Performance measurement is also needed for pricing purposes, especially in the case of performance partnering, where the customer is paying for performance. This requires precise and measurable indicators as well as a monitoring system. However, it is necessary to make sure that the contract or its outcomes are worth investing in complex quality and performance monitoring and the most cost-effective approach is adopted.

Performance indicators can be classified into two types: lagging indicators (outcome measures) and leading indicators (service performance drivers). A good linkage between lagging and leading indicators makes it possible to control service performance. Kumar and Ellingsen,8 and Hall and Rammer,9 define performance indicators as quantitative and qualitative statistical information which is used to assist in determining how successful an organization is in achieving its objectives. They suggest that performance indicators can measure three main aspects of performance: workload, efficiency, and effectiveness measures.

Efficiency measures generally measure productivity: input/output ratios, and equipment and personnel utilization rates.

Effectiveness indicators are designed to measure the extent to which the objectives of the organization have been achieved, and they include the quality of services, the levels of customer satisfaction, and overall outcomes such as profitability or accountability for equity.10

Customers often have technical requirements of high efficiency and uptime, excellent output quality, as well as low operational and maintenance costs.

Downtime is a function of how easy, safe and economical it is to perform maintenance; how effective the administrative routines are for scheduling, planning, and executing maintenance; as well as the availability of spare parts, expert assistance, repair tools and so on.

Uptime is measured by availability, and depends on the system’s reliability and maintainability characteristics, as well as supportability, which is a measure of how easy, cost effective and safe it is to support the product.11

Reliability is a measure of how often the system fails, and is commonly measured as the mean time between system or component failures or the mean time to failures.12

Maintainability is a measure that reflects how easily, accurately, effectively, efficiently, and safely the maintenance actions related to the product can be performed, and is often measured by the mean time to repair time (MTTR), which includes the total time for fault finding, and the time needed for the repairs.13

Performance indicators

Performance indicators include:14
• equipment availability and faults (MTBF, MTTF downtime by day/hour, number of customers impacted and cost of impact);
• other faults impacting on service (downtime by day/hour, number of customers impacted);
• total problems (number, severity, and time to rectify);
• job completion (time in various categories);
• utilization and capacity (forecast versus actual);
• output (against accuracy targets, against target deadlines, effectiveness);
• delivery mechanisms (against target deadlines, against in-transit defect targets)
• price/cost;
• safety and environmental performances (for example, average number of incidents);
• on-time performance (for example, MTTR, by type of job or transaction);
• work quality/rework; and
• amount of work.  

Katri Rekola,
PhD (econ.), MSc
(Production economics),
Managing director,
Rekola Design Oy,
Email: Katri.Rekola@Kolumbus.fi,
www.tuotekehitys.info.

Endnotes
1. Markeset, T and Kumar, U. “Product Support Strategy: Conventional versus Functional Products”, Journal of Quality in Maintenance Engineering 11/1 2005.
2. Kumar, R and Kumar, U.
“A Conceptual Framework
for the Development of a Service Delivery Strategy for Industrial Systems and Products”, Journal of Business & Industrial Marketing 19/5 2004.
3. Markeset, T and Kumar, U. “R&M and Risk Analysis Tools in Product Design to Reduce Life-cycle Cost and Improve Product Attractiveness”, Proceedings of the Annual Reliability and Maintainability Symposium 2001; and van Baaren, R.J; Smit, K. “A Systems Approach towards Design for RAMS/LCC”, Proceedings of the 8th Annual International Cost Engineering Congress 1998, 2000.
4. Above note 1.
5. Malleret, V. “Value Creation through Service Offers”, European Management Journal 24/1 2006.
6. Stremersch, S; Wuyts, S and Frambach R.T. “The Purchasing of Full-service Contracts”, Industrial Marketing Management 30 1-12 2001.
7. Rekola, K and Rekola, H. (2003) Palvelukeskeisten järjestelmätuoteiden kehittäminen valmistavan teollisuuden yrityksissä. (Developing Product-centric Service Products in Manufacturing Companies) Helsinki: Teknova.
8. Kumar, U and Ellingsen, H.P. “Development and Implementation of Maintenance Performance Indicators for the Norwegian Oil and Gas Industry”, Proceedings of Euro Maintenance 2000.
9. Hall, C and Rimmer, S.J. “Performance Monitoring and Public Sector Contracting”, Australian Journal of Public Administration 53/4 1998.
10.  Dean, A.M and Kiu, C. “Performance Monitoring and Quality Outcomes in Contracted Services”, International Journal of Quality & Reliability Management 19/4 2002.
11.  Above note 1.
12.  Blanchard, B.S; Verma, D and Peterson, E.L. Maintainability: A Key to Effective Serviceability and Maintenance Management, John Wiley & Sons, New York, 1995; and Dhillon, B.S. Engineering Maintainability: How to Design for Reliability and Easy Maintenance, Gulf Publishing, Houston, 1999.
13.  Above note 2.
14.  Above note 2; and Bertolini, M; Bevilacqua, M; Braglia, M and Frosolini, M; “An Analytical Method for Maintenance Outsourcing Service Selection”, International Journal of Quality & Reliability Management, 21/7 2004; and Hiles, A. Service Level Agreements, Chapman & Hall, UK, 1993.
 
 

 


 

Evaluating public procurement: a platform for discussion - RAND Europe

 
A discussion of two areas of the “Working Report” by RAND from the 2007 survey of IACCM members’ experience in public procurement. (1) Public procurement is slower, more costly and less profitable than private sector procurement; and (2) the approach of procurement authorities in allocating risk is problematic, as it excludes potential suppliers and reduces value for money for the public. KAREN NORTHEY, BT Global Services
 
 
By Karen Northey, BT Global Services

In May 2007, IACCM members were asked to participate in a survey addressing their experiences in public procurement. The results of that survey (which are available in detail on the IACCM website) have been used as a key part of a recent “Working Report” released by RAND Europe, an independent think tank whose mission is to help improve policy and decision making through research and analysis.

The report, titled Evaluating Public Procurement: a Platform for Discussion identifies and analyses weaknesses in public procurement practices in Europe, with a particular focus on information and communication technology (ICT) procurement and provides some insightful and useful recommendations on how to improve the public procurement process to the mutual benefit of suppliers, the authorities and the public at large.

The report is useful reading for anyone concerned about the financial considerations in contracting, as it highlights key issues in terms of cost and risk allocation for potential suppliers in participating in pubic sector projects. Based on extensive reviews of results from the literature and new research as well as key informant interviews, the report highlights that public procurement is slower, up to twice as costly, and less profitable than, private sector procurement. Given that the public sector is by far the largest purchaser of goods and services in the EU (approximately 16% of EU GDP), the public procurement process has significant influence over the development of a single market and the promotion of competition and innovation. However, the report confirms the tendency of current public procurement practices throughout the EU to defeat established policy objectives.

This article focuses on just two of the problematic areas raised in the report: first, the fact that public procurement is slower, more costly and less profitable than private sector procurement; and second, that the approach of procurement authorities in allocating risk is problematic, as it excludes potential suppliers and reduces value for money for the public.

Public procurement is slower, more costly and less profitable than private sector procurement

The stakeholder interviews conducted for the RAND report outlined that public procurement is on average 100–130% more expensive than analogous private sector procurement. Furthermore, the IACCM survey found that public procurement policies and negotiation behaviors in the EU diminish value and raise costs by an average of 28%. But overall costs, according to the RAND study, may in fact be even higher when the cost to the procuring authorities and other bidders are taken into account. This is compounded by the fact that margins and other long-term benefits would appear to be lower for public sector bids than for the private sector. The study attributes this to factors such as transparency rules, requirements for repeated competitive tenders, and simplistic gain sharing arrangements which limit incentives to invest in long-term relationships and realize shared productivity and quality gains. It would be tempting for the contracting authorities and the general public to think that lower margins for suppliers would ultimately be beneficial to the public interest and result in better value for money. However, as the authors mention, these reduced margins do not necessarily result in better value for money, and can just as easily be attributed to increased transaction costs and the inability of suppliers to hedge risk — leading ultimately to many suppliers being unwilling to participate in public bids.

Inappropriate risk allocation

The inappropriate allocation of risk is raised in many areas of the report and has been attributed to a number of negative consequences. Generally speaking, the report highlights the “institutional culture of risk aversion”. Part of this is attributed to historical poor cost performance of large ICT projects which has put pressure on officials who have responded by trying to shift risk and focus too heavily on short-term cost control at the expense of long-term economic advantage. It has also served to remove incentives for any improvements which do not address cost control. One of the ways that this has manifested itself is in the over-reliance on standard term contracts with no (or very limited) room for negotiation. There is a culture within the public sector whereby procuring agents will avoid varying standard terms, will shift risk, and tend to choose larger more established suppliers in order to minimize the risk of any blame falling to themselves in the event of projects going wrong. It is suggested that this approach is seen by procuring agents as a means of protecting themselves against allegations of corruption.

There are a number of problems with this culture of risk aversion and over-reliance on standard terms. In Annexes 2 and 3 of the report, RAND provides a table of typical standard clauses which either have a discriminatory impact or favour local and incumbent bidders. Some of the clauses highlighted include unlimited and one-sided indemnity provisions, no minimum volume commitments, parental guarantees, long payment terms and excessive late delivery penalties. These clauses can also increase the cost and risk for bidders.

The solutions

The overarching message of the report is that the problem lies with the procurement practices of contracting authorities rather than the rules themselves.  What is required is a change in attitude and approach by procuring authorities that leads to a better application and interpretation of existing rules. As stated in the report: “What is needed is much greater recognition by public sector purchasers of the problems, a realization that this is a critically important issue for the single market in the EU, better and more consistent understanding of the legal principles and, above all, the recognition of the importance of the procurement officer in our public institutions”.

Some of the changes to current public procurement practices which RAND suggests in its report include:
· the selection of “the most economically advantageous tender” while limiting the selection of ‘lowest-price conforming bid’ to straightforward purchases;
· standard model contract terms and conditions should be redesigned to fit specific circumstances and should not be seen as compulsory but, rather, as a uniform starting point;
· tenders inviting variants as well as alternative tendering processes should be encouraged;
· education should be provided on how to exercise judgment in a proportionate manner, and to reinforce that principles of equal treatment and non-discrimination do not mean that all cases must be treated in the same way.

 

Many of these practices can be addressed through two other recommendations of the report:

· the creation of a government/industry procurement forum for the IT sector; and 
· a procurement handbook and guidelines for the IT sector.

With regard to the specific issue of risk allocation, the report recommends a greater sharing of risk — particularly where the parties are equally well-placed to manage risks, or the risks should be borne by the party best able to bear them. Furthermore, the report stresses the need for reduced reliance on risk shifting provisions, such as parent company guarantees, service level credits and unlimited liability obligations.
Many of these recommendations can and should be promoted by members of the IACCM as a mutually beneficial change to procurement practices.

Karen Northey,
Director, Global Government Affairs,
BT Global Services,
Karen.Northey@bt.com,
www.btglobalservices.com.

 
 

 


 

 

 


 

Some perspectives on revenue recognition from IACCM members

 
IACCM members share their experiences in revenue recognition in this introduction to the topic. Mark David introduces the accounting and regulatory background; Nigel Cairns shares his experiences on “claw-back”; Craig Guarente takes the perspective of a service provider; and finally, the importance of collaboration at an early with functional experts for optimal outcomes is discussed. Mark David, CommitMentor, Nigel Cairns, EDS, an HP Company & CRAIg Guarente, Oracle (Photos: Mark David & Craig Guarente)
 
 

By Mark David, CommitMentor,
Nigel Cairns, EDS,
an HP company &
Craig Guarente, Oracle
 

Mark David distills some important points for contracts professionals from a recent discussion on revenue recognition with IACCM members, including Craig Guarente and Nigel Cairns

There are many detailed dimensions in exploring the world of revenue recognition. What may appear to some to be an unexciting, irrelevant world full of intricate accounting minutiae, has a practical relevance to commercial contract professionals around the world. In advance of these dimensions being explored in a later issue of Contracting Excellence, we have solicited some personal perspectives to stimulate thought and encourage discussion. These are the personal views of IACCM members and do not necessarily represent the views of their companies and, as you will see, they illustrate the importance of the role of commercial contract professionals as well as differing perspectives.

“Revenue recognition” is the term commonly used to refer to the accounting rules governing whether or not revenue can be shown in a company’s accounts. There are different rules depending on the accounting jurisdiction within which the accounts are being prepared and the type of transaction. Possibly the “most famous” revenue recognition rules are those governed by SAB 101 under US GAAP which state that generally revenue may be recognised when all of the following criteria are met:

1. persuasive evidence of an arrangement exists;
2. delivery has occurred or services have been rendered;
3. the seller’s price to the buyer is fixed or determinable; and
4. collectability is reasonably assured.

These apparently simple four rules trigger a large number of detailed issues that need consideration. What might be thought of as an issue that lends itself to a “yes” or “no” decision, actually entertains a rich variety of “it depends” situations. At the extreme, the ability to make judgments provides the possibility for decisions to be made that bend the rules too far and become illegal. In this situation, commercial contract professionals have been caught up in investigations where the act of drafting contractual language is viewed as being an integral part of the alleged illegal activity.

In my experience working with and talking to commercial contract professionals who work for US companies, the issue of revenue recognition is seen as the issue with the biggest challenges. There are many reasons for this reaction including:

· accounting rules that aren’t necessarily understood;
· the feeling that splitting cash from revenue splits financial objectives from “common sense”; and
· the pressures to recognise revenue at the earliest opportunity without necessarily looking at what is sound from contractual, project, relationship or margin perspectives.

Meanwhile, those on the buy-side are left under-whelmed by the discussion and frequently troubled if a supplier raises the revenue recognition issue in negotiations. 

It is interesting to observe that revenue recognition is not an issue on which procurement professionals necessarily feel they should be up to speed. There are too many occasions when contract terms are presented to suppliers even though they mean that revenue can never be recognised. Should buyers concern themselves with such matters? Regardless of the importance of building an effective supplier relationship in situations where the success or failure of the supply chain determines the success or failure of a company, why would a supplier want to supply to a customer without the possibility of revenue being recognised?
 

Nigel Cairns shares some lessons learned on claw-back

Revenue recognition and cash flow should not be confused and I share an example of why understanding the difference is important. The UK government likes to have the right to claw money back. This means that the client has the right to take back (claw back) any money paid out (your revenue) for interim milestones if the final milestone is not met; and this means that the revenues cannot be recognised in the profit and loss statement until the final milestone has been achieved.

There are two disadvantages for the supplier here. If it does not achieve the final milestone the money received for interim milestones will have to be returned; and this makes it difficult for the supplier to recognise the revenue for the interim milestones, as there is a chance that it will have to pay it back. There is, however, a view that the revenue can be recognised if one is certain of achieving the final milestone. So, from a revenue recognition perspective, this claw-back mechanism is a problem.

However, from a cash flow perspective, the claw-back mechanism could be seen as good news. Without this mechanism the government, as a client, would be unwilling to make any payments until the final milestone, and that would give the supplier the problem of financing the work. With a claw-back mechanism in place the parties can agree on interim milestones that allow the supplier to keep its cash flow neutral or positive for most of the project. 

Why do rules that are apparently
simple in concept seem to create
so much work in practice? 

The rules are apparently simple in concept, but they can cause a great deal of trouble for companies that focus on quarterly results, as they want to recognise cash as soon as it is received, but may not be permitted to do so by the revenue recognition rules as interpreted with the relevant contract terms.

Because we are talking about something that affects profit and loss, revenue recognition — or the lack thereof — can and does affect the share price and, therefore, can affect business valuations. 

Add to this bonuses that are based on recognised revenue (as opposed to some other measure like TCV (total contract value)) or share price, and you have a group of people who have a vested interest in revenue being recognised as early as possible, resulting in pressure on the deal team to try and deliver on this.

However, if you take a longer-term view than most Anglo-Saxon based companies, then, provided you have a balanced portfolio and sufficient cash flow, does it matter whether you recognise the revenue this quarter, the next or the one after that? 

It’s an old-fashioned view and none the worse for that — follow the cash first and foremost, then concern yourself with profit, and finally assess when that profit can be recognised. To come unstuck on a profitable deal which has good cash flow with a decent break-even point because the revenue cannot be recognised until later than one would like is, in general, unwise. On the other hand, if we were to take a portfolio approach to our business, it is likely that we would endeavour to have a mix of projects: some providing the ability to recognise revenue immediately, allowing the supplier to be more relaxed about those that do not. Some would give early break-even and some later, some small margins and some large, and so on.
 

Craig Guarente looks at revenue recognition from the perspective of services, where revenue is generally recognizable when the services are performed

While I agree in theory that getting the cash is of utmost importance, revenue recognition should be at least as important. Perhaps it depends on the product being offered.

For a software license, revenue is key, and software providers generally try to recognize all license revenue upfront. Companies have been able to eliminate some of the barriers to revenue recognition; for example, the shipment obligation can be eliminated by allowing instant downloadable access to software via the web. Payment uncertainties can be minimized by using a third-party financing company, which will assume the risk of payment for a fee. 

There is not the same upfront revenue recognition push in services where projects take time to complete. Revenue for services (consulting and maintenance) is generally recognizable when the services are performed. For example, if a customer pays for one year of maintenance upfront, that money can be recognized weekly, monthly, quarterly, or in arrears, depending on the rules followed at that company.

The real issue behind being so focused on recognizing license revenue may be Wall Street. The financial market looks at that license figure when earnings are announced. If the market were not so focused on it, then perhaps vendors would not be either.

Collaborate with the relevant functional experts to promote optimal outcomes

Another member of the discussion emphasises that it is critical to collaborate with senior members of different functional areas to get their advice early in the negotiation process, and to develop standard contract templates that comply with accounting/revenue recognition rules, while at the same time fulfilling the requirement of delivering a fair/balanced contract that is acceptable to customers.

Ask yourself the following two questions.

What success have you had
with engaging your accounting/
finance department to assist with revenue recognition matters?

When encountering ‘technical’ contract matters such as patents, product specifications or service level agreements), contract and commercial professionals will generally consult with a suitable functional expert. This should also be the case with revenue recognition matters. Most auditors/accountants will welcome the opportunity to review and explain complex accounting matters, and to become involved early in the negotiation process. Their complaints come when they have been called in too late to make a difference in the negotiation process.

What success have you had in
collaborating with senior members
 of sales, finance, legal, and
contract management teams to
develop standard contract templates
that meet accounting/revenue recognition rules?

The use of templates and processes can simplify the complexity of crafting a contract and enable the prompt resolution of matters when complexity creeps in to the negotiation process; such as when a third party (either a customer or a supplier) requests a change to a key or sensitive contract clause. Building “collaboration bridges” upfront with other functional groups, will prove useful and supportive when the time comes to work through a difficult negotiation process. Remember that these are two-way bridges — not gaps that you throw issues over to let the other side deal with. By working together, we create the best outcomes.

 
Mark David,
Principal, CommitMentor,
Editorial panel member, Contracting Excellence,
Email: mark@commitmentor.com,
<www.commitmentor.com>.
 
Nigel R Cairns,
Commercial Operations Director,
EDS, an HP company,
Email: nigel.cairns@eds.com.
 
Craig Guarente,
VP, Global Contract Services,
Oracle USA, Inc,
Editorial panel member, Contracting Excellence,
Email: craig.guarente@oracle.com.
 
 

 


 

 

 


 

Driving better fiscal management and revenue recognition with enterprise contract management technologies

 
Enterprise contract management technology can play an important role in improving a company’s fiscal management and results, ensuring proper revenue recognition; revenue maximization; and speeding the sales and revenue recognition process. KEVIN POTTS, Emptoris
 
 

By Kevin Potts, Emptoris

Main Points

• CFOs are faced with increasing pressures from compliance to cost controls to revenue recognition.
• Global 2000 companies are increasingly turning to enterprise contract management (ECM) solutions for better contract management and fiscal management.
• Improved contract management can mitigate financial risks, lead to more profitable contracts and speed revenue recognition.

A fast-growing trend in fiscal management is a focus on improving contracting processes and strengthening contracts, and the application of ECM technologies toward these ends. Such technologies have long been used to impact the bottom-line, but most commonly applied by procurement organizations to help manage and reduce costs — or by legal and contract professionals to more efficiently and effectively manage contracts, processes and corporate compliance. However, beginning with the increased regulatory requirements of Sarbanes-Oxley and accelerated by the drive to control costs and better manage revenue at the onset of an economic downturn, usage of contract management technologies by the financial operations within Global 2000 companies has been accelerating.

Of course, contracts are the foundation of every business and every business relationship. Contracts dictate virtually every aspect of a business and customer relationships, including payment terms, service levels and pricing. Thus, contracts also play a central and critical role in the sales-to-cash process. 

ECM technologies can play a critical role in fiscal management, from controlling spending and mitigating financial risks, to managing compliance and speeding revenue recognition.

The average Global 1000 corporation maintains over 40,000 active contracts, and the number and complexity of those contracts is growing. Yet, most enterprises still struggle to manage those contracts, particularly when managed manually or with very limited applications, such as the limited contracts capability available with their enterprise resource planning (ERP) systems. The manual or low-tech approach to contract management exacerbates existing pressures, causing lack of visibility into legal and financial risk; maintaining the status quo “file and forget” un-auditable paper trails; and relying on deficient contract approvals and compliance checks. Addressing these pressures is rarely as simple as adding processes or personnel, particularly with trends toward reducing staff costs. 

So where are global companies turning? Consider that nearly all the productivity gains US companies have made in the past 25 years have come via the application of new technologies. With admitted bias, I think best practice dictates the application of best-in-class ECM technologies to manage contracts and the contracting process. Fortunately, leading independent analysts and a significant and growing number for CFOs at Global 2000 companies agree. 

ECM solutions provide the visibility and control needed to create better contracts, actively manage the contracting process, ensure contractual obligations are met, and accurately manage and speed revenue recognition. They can help manage across the entire sales-to-cash process, from initial sales proposal through contract creation, negotiation, and acceptance. ECM solutions can also help manage across the enterprise, from sales operations, field sales and planning, to finance, legal and operations.

Four areas where ECM can improve fiscal management

Below, I outline four specific areas where improved contract management and ECM technology can be applied to improve the fiscal management of the global corporation:

1. Drive compliance and reduce risks

From Sarbanes-Oxley, to the Securities Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) rules, the fiscal management of a Global 2000 company carries with it significant compliance requirements over and above the demands of running a fiscally tight ship. 

Many companies are handcuffed in their compliance efforts by a significant lack of visibility into legal and financial risks, and the inefficiency and limitations of their contract preparation and approvals processes. 
With the right technologies, companies can ensure and enforce compliance by building in proper contract review and approval procedures and by providing greater and more timely visibility into financial and legal exposures.

In the study entitled Contract Lifecycle Management and the CFO, published by the independent analyst firm, the Aberdeen Group, it was found that upwards of 65% of enterprises using ECM solutions reported immediate benefits in their visibility into and identification of financial and legal risks. 

With a contract management solution, companies have a library of contract templates with approved language, and alternative and “fall-back” clauses to quickly produce stronger contracts in compliance with regulations and internal rules and controls. Contract creation wizards can enable self-service contract creation by front-line personnel while still ensuring compliance and approvals of any notable modifications or anomalies.

Further, complete transparency across the full contract lifecycle enables cross-functional cooperation and accountability, and a clear audit trail that makes any deviations from internal rules and controls readily apparent. Finally, a central contract repository, and rules-based notifications and alerts help ensure companies have broad and immediate visibility into the contracts at the heart of their revue generation

2. Ensure proper revenue recognition

Contracts also play a central role in revenue management including:

• forecasting revenues;
• ensuring proper revenue recognition;
• certifying that financial statements are accurate and complete; and
• generally managing cash flow and revenue. 

Best-in-class contract management software can help ensure proper accounting of revenues (and spend) in terms of accounting rules and guidelines. Of course, in a worst-case scenario, poorly written contracts can lead to revenue recognition issues and revenue restatements.

With the complexity of today’s sales agreements and revenue recognition, particularly in industries such as high-tech and software with multi-element contracts, contract management solutions can help ensure the appropriate accounting of revenue, including when and how it is recognized. Using the contract management solution itself, or through integration with billing or accounting software, companies gain direct visibility into and automatic alerts on schedules and milestones in contracts that impact revenue. 

By automating processes and improving visibility into the contracts that are at the heart of revenue generation, companies create a strong foundation of internal controls over revenue processes. This leads to greater integrity and accuracy of revenue data.

Having a library of standard contract terms related to revenue recognition business rules allows companies to ensure that best practice in revenue recognition is consistently applied. And an automated approval process allows for more efficient management and ensures review of non-standard contract terms, specifically those that would impact revenue recognition. Finally, contract management solutions offer a reliable, consistent and efficient manner in which to review and report on revenue aspects of contracts, allowing for quicker insight into risks and quicker resolution of potential problems.

3. Capture and maximize revenue

Another research study by the Aberdeen Group among Global 2000 companies found that poor contract management in the sales-to-revenue cycle results in revenue leakage, on average, between 5% and 9%. Thus, even under a conservative scenario, for a company with just over $1 billion dollars in contracted sales, revenue leakage could run between $50 million to $90 million. Capturing just half of that can add tens of millions of dollars back into a company’s revenue stream. Obviously, in today’s economic environment, that revenue is especially important to capture. And capturing that leakage is highly achievable. In the Aberdeen report, best-in-class companies in terms of contract management had leakage at just a fraction of the average company.

Revenue leakage can result from a range of problems — from sub-optimum or missed contract renewals; improper invoicing, to regulatory fines or penalties.

Contract management solutions allow companies to capitalize on each renewal opportunity by identifying upcoming renewal candidates, notifying internal and external parties through dynamic workflow rules, automatically generating renewal contracts, and initiating processes in other enterprise systems. The result is higher renewal rates, higher revenue through stricter enforcement of pricing terms, and lower contract renewal and administration costs.

A contract management solution also allows companies to monitor customer (and supplier) performance against commitments and conduct timely audits, performance checks and reviews so that the value of contracts is maximized. (On the buy-side, companies capture more savings opportunities by ensuring that they obtain the discounts and rebates they’ve negotiated with suppliers.) 

Finally, contract management solutions allow companies to structure more profitable deals by leveraging information from all historical contracts, and from other enterprise solutions, to give an edge in the negotiation of contracts. The solution also improves contract quality by enabling professionals across functional areas to develop contracts collaboratively, and gives senior management clear dashboard visibility into key contracts and key terms.

4. Speed sales and revenue recognition 

An additional benefit of improving contracting processes and applying contract management technologies is in speeding the sales and revenue recognition processes.

The process of managing deals from initial sales proposal through to contract creation, negotiation and execution typically involves numerous resources across an organization. In most organizations, sales operations, field sales, finance, legal and consulting are involved in the sales process. Coordinating the process across all resources, while ensuring deals contain only accurate and beneficial terms, can be time consuming and challenging, to say the least. 

According to one study, each day a contract is delayed in the sales cycle at a Global 2000 company results in an estimated reduction of $88,000 to the bottom line of the company through both time-costs and lost revenue. Obviously, situations vary by industry and contract, but just think of that as your general yard-stick — close to a half-million dollars a week for contract delays.

“Companies using contract management solutions to enforce systematic and efficient procedures for creating, executing and managing corporate contracts have been able to cut process cycles in half, reduce contract administration costs, improve contract compliance by 50% to 55%, diminish risk and increase revenues and profits,” according to the Aberdeen Group. One medical technology company we worked with saw a reduction of roughly 60% in time spent creating, negotiating and approving contracts. The Aberdeen report found similar successes, with best-in-class companies applying ECM technologies taking just 20 days to go from contract creation and negotiation to approvals, compared to more than 30 days on average for Global 2000 companies in general.

Another technology service company we work with has reported that they halved the time required to close contracts using ECM technology. They commented, “This enables us to accelerate revenue each quarter. We could bring forward tens of millions next year, and ever greater revenue numbers in future years.”

So, whether it is speeding sales and revenue processes; capturing and maximizing revenue; or ensuring proper revenue recognition and compliance to revenue recognition rules, enterprise contract management technologies can play a significant role in compliance and driving a bottom-line impact. 

Kevin Potts, Vice President of Marketing and Product Management, Emptoris,
Email: kpotts@emptoris.com,
www.emptoris.com.

Emptoris is a leading supply and contract management software company.
For further information about the studies cited, please contact the author.

About the author

Kevin Potts works with customers, industry leaders, and the media to share the vision for how Emptoris’ innovation accelerates profitable growth.

Kevin has nine years of enterprise software experience, including seven years in supply and contract management applications.

Prior to joining Emptoris, Kevin worked with McKinsey & Company, and he served in the U.S. Marine Corps and is a decorated combat veteran. He has a BSc in Systems Engineering from the U. S. Naval Academy and an MBA from Stanford University.
 
 

 


 

 

 


 

Wise working capital management: cash may be king. Just don’t kill your subjects.

 
Pressured to stabilize profits and improve cash flow, too many companies are employing myopic approaches by putting the onus on the weakest links in the supply chain, namely, suppliers. In recent times, big companies have announced that they will extend payment terms with suppliers. Withholding cash will only increase the incidence of supplier bankruptcies, which are already at all time-high levels, and could negatively impact service levels and will certainly strain supplier relations. DREW HOFLER and TIM MINAHAN, Ariba (Photos: Drew Hofler & Tim Minahan)
 
 
By Drew Hofler and Tim Minahan, Ariba

In today’s sagging global economy, cash is most certainly king. To protect their businesses and ensure sufficient cash flow in this tight credit environment, enterprises are doing everything they can to hold on to the cash they have and free up even more liquidity by lowering their net working capital.

Of the three levers affecting working capital (inventory, receivables, payables), the one companies have the most immediate control over is “days payable outstanding” (DPO). Unfortunately, many enterprises are trying to solve their DPO challenges by putting additional burden on the part of the supply chain least prepared to bear it — suppliers.

In recent weeks, some of the world’s largest companies — from Ford Motor Company in the US to Tesco in Europe — have announced plans to at least double their payment terms with suppliers. Such stall tactics are myopic at best, putting your company at risk of supply disruptions and operational challenges as suppliers struggle with their own cash flow issues and lack of access to credit. (And, as the automotive industry has learned in the past, suppliers are like elephants: they never forget. If you delay supplier payments, don’t expect top-notch service.)

A recent Wall Street Journal article put it candidly: “If you look at a big company that pays in 45 days instead of 30, that’s a huge amount of cash [to the supplier]. And everyone’s looking for cash flow” (Kelly Spors & Simona Covel “Slow payments Squeeze small-business owners” 31 October 2008.)

Make informed payment decisions

Now is the time to create greater efficiency and transparency in your invoice reconciliation and payment processes so you can make informed decisions as to whether to pay suppliers on time or even (gasp!) early to take advantage of early pay discounts and to keep your suppliers in business. Many cash-hungry suppliers will even likely reward you with additional rebates for early payment.

Consider one technology company who secured 60 day payment terms from customers but paid its suppliers net 75 days. When two suppliers went belly up because they didn’t have the cash to fund operations, the company was sent scrambling to find alternative supply.

One of the quickest ways to get cash under control is to automate the invoicing and payment process. This removes invoice approval process latency, gives you clear visibility into your commitment and payment streams, ensures invoice and payment accuracy and increases rebate and discount capture. Most importantly, this new efficiency and visibility allows you to make informed payment decisions based on cash needs, early-pay discounts and rebates, and overall supplier viability.

Companies that have automated their invoicing and payment processes report that suppliers typically grant concessions of 0.5% to 3% or more (up to 4% in some cases) for accelerated payment. And that type of return can mean the difference between achieving your company’s cost savings and profitability goals or becoming another victim of today’s uncertain global economy.

Consider third-party financing

If you must extend DPO, use a third-party supply chain financing partner to lessen the risk (and burden) on the supply chain. That way you can hold onto your cash longer, and still give your suppliers the opportunity to be paid early, while the financial intermediary takes on the risk and injects much needed liquidity into the supply chain. Third-party financing:

· helps buyers extend payment terms by off-setting the term impact with low cost early payment;
· can reduce buyers’ payment costs;
· allows suppliers to be paid early while the buyer holds on to their cash;
· leverages buyers’ credit strength and cost of capital to significantly lower suppliers’ short term financing costs; and
· best of all, it costs buyers nothing. 


The global economic slump has hit nearly every industry in nearly every corner of the globe. With credit tightening even for the largest enterprises, cash has become key not only to their competitiveness, but also to their survival. The future kings of industry will be those that can figure out a way to maximize cash flow over the next 12–18 months, without devastating the kingdom.
 
Drew Hofler,
Senior Manager, financial solutions products, Ariba,
Email: dhofler@ariba.com; and
 
Tim Minahan,
Chief Marketing Officer, Ariba.
tminahan@ariba.com
www.ariba.com

About the authors

Drew Hofler is responsible for Ariba’s Working Capital Management suite of solutions, including discount management, third party financing, and receivables financing. He joined Ariba from PNC Bank, where he served as VP, Senior Product Manager in Treasury Management responsible for supporting PNC’s ACH and Liquidity Management solutions.

Tim Minahan is responsible for the design and execution of Ariba’s global marketing programs including branding, corporate communications, marketing communications, product marketing, Web marketing, sales support, demand generation and analyst relations. He joined Ariba from Procuri, where he served as senior vice president of Marketing and worked closely with the executive leadership team in shaping the strategic direction of the company’s growth. Prior to that, Tim headed research services at the AberdeenGroup, where he was recognized as one of the most influential experts on technology, supply chain, and contract management issues.

 
 

 


 

Cynthia Hollinsworth, Commercial Manager Europe for FKI Logistex, a global materials handling solutions integrator, maximized on a business/negotiating trip to China and visited the Wén Miào Temple, the only surviving Confucian temple in Shanghai, founded during the Yuan Dynasty (1271-1368 AD) and most recently restored in 1999 to celebrate the 2,550th birthday of Confucius.

Near the entrance to the temple is Kuíxing Gé, a three-story, 66-foot pagoda dedicated to Confucius, China’s great thinker, philosopher and founder of the Confucian culture, born in 551 BC, who devoted his life to creating a set of ethical principles centered around the ideals of harmony and stability. She says she learned how Confucian ethics and philosophy apply as much in business today, as it did then, such as the practiced art of slowing down the pace of the negotiating process and non-confrontational, harmonious culture - Confucius said “A little impatience ruins a great plan”.

 

 

 

 

Outside contracting — contribute to this column

Do you have a special activity or achievement in your life outside of contracting? If so, send photos and a 100-word description to Suzanne Birch at <sbirch@iaccmresourcing.com> for consideration to publish in this column.

 

 

 


 

 

 


 

Denmark

 
IACCM representatives regularly visit different countries, helping companies and institutions understand best practices in the management of trading relationships and contracts, and promoting the association’s research and services. The story and more photos......
 
 
IACCM representatives regularly visit different countries, helping companies and institutions understand best practices in the management of trading relationships and contracts, and promoting the association’s research and services.
 
Earlier this month,  IACCM undertook several meetings and presentations in Denmark, with organisers including  Tim Cummins, Director, and Sandra Lewy, Business Analyst, IACCM; Jean Marc Fraisse, Novo Nordisk Engineering; Martin Randrup Andersen; Contract manager, Terma; Michael Pedersen, Senior legal counsel, Grundfos; Henrik Lando, Professor, Copenhagen Business School; René Franz Henschel, Associate Professor, Aarhus School of Business and Jens Erik Hansen, Danske Bank.
 
The first meeting was with Danske Bank contracts and procurement personnel. Tim Cummins made a presentation on Strategic Commitment Management and the ways that IACCM can help, and answered questions related to outsourcing, data centre operations agreements, service agreements on IT-services, and contracts development. 
 
Following this, Tim presented a lecture at Copenhagen Business School on: ‘What is contracting excellence and why does it matter?’ Guests at this meeting included approximately 60 students and a number of IT-Contract Managers, Lawyers and Procurement Managers from local companies.
 
Later in the day, IACCM held a meeting at NNE (a healthcare company), which was organised by Jean Marc Fraisse. More than 50 attendees included contract managers, project managers, and lawyers from different companies. This was followed by an informal business dinner, organised by Rene Henschel. This gave an opportunity for those who had met earlier to discuss the presentations, lectures, and also their future relationships with IACCM and included participation by a leading member of the Danish Supreme Court.
 
The following day included a meeting at Grundfos, with the Senior Legal Counsel and other Legal employees. Grundfos organised a show tour around their factory, and then a meeting with contract managers and lawyers from leading companies in the Jutland region about organizational and professional excellence in contracting and commercial management.
 
The visit to Denmark identified that there is significant interest in contract management in this area, as well as a need for IACCM’s services. Many business practices are rooted in tradition, and the discussions explored the impacts of golobalisation and increased business complexity in driving a need for a more robust contracting process.
 

As a result of these meetings, IACCM is pursuing requests from local members to stage a Nordics conference in Copenhagen during the early part of 2009. The meetings also led to a number of companies finalising their Corporate Membership with the association.

 

 

 

 

 

 

 

 

 

 

 

 
 

 


 

 

 


 
 
 

Editor
Kerrie Tarrant

Consulting editor

Tim Cummins, CEO, IACCM

Vice President of Research and
Advisory Services, and Advertising
Sales enquiries

Katherine Kawamoto

Editorial Panel
Mark David, CommitMentor, UK.
Rose Gazarek, BAE Systems, US
Craig Guarente, Oracle, US
Helena Haapio, Lexpert Ltd, Finland
Christof Hoefner, IBM, Germany
Bruce Horowitz, Attorney/Arbitrator, Ecuador
Doug Hudgeon, Macquarie Bank Ltd, Australia
William Knittle, BP, UK

Automation and technology panel
Mark Darby, Alliantist, UK
Ashif Mawji, Upside Software Inc, Canada
Tim Minahan, Procuri, US
Terry Nicholson, Selectica, US

Address: International Association for Contract & Commercial Management (IACCM), 90 Grove Street, Ridgefield, CT 06877 USA. Ph: (1) 203 431 8741, www.iaccm.com
Editor: ktarrant@iaccm.com
Sales enquiries: kkawamato@iaccm.com

This issue may be cited as (2008) 2(2) Contracting Excellence.
ISSN: 1937-9765; ISSN: 1937-9757

Disclaimer

This newsletter is intended to keep readers abreast of current developments in the field of contract and commercial management. It is not, however, to be used or relied on as a substitute for professional advice. Before acting on any matter in the areas, readers should discuss matters with their own professional advisers.

This site is provided by IACCM on an 'as is' basis. IACCM provides this web site as a service to those people seeking contracting and commercial news and information. IACCM assumes no responsibility for consequences resulting from the use of information on the site or information obtained through links. IACCM will not be liable for any damages of any kind arising out of use, reference to, or reliance on any information contained in the site. IACCM is not responsible for the accuracy or content information contained in the site or in the links provided on its site. Links to and from IACCM do not constitute an endorsement by IACCM of the parties or their products and services.

Copyright

The content in this publication is copyright. Excepted as permitted, no part of this publication may be reproduced by any process, electronic or otherwise, without the specific written permission of the copyright owner.

All content included on this site, such as text, graphics, logos, button icons, images, audio clips and software, is the property of IACCM, or its content suppliers or an identified third party and is protected by international copyright laws. The collection, arrangement and assembly of all content on this site is the exclusive property of IACCM and is also protected by international copyright laws. Any reproduction, modification, distribution, transmission, republication, display or performance, of the content on this site is strictly prohibited.

Use of this site

This site or any portion of this site may not be reproduced, duplicated, copied, sold, resold or otherwise exploited for any commercial purpose that is not expressly permitted by IACCM. Unauthorized attempts to upload information or change information are strictly prohibited and may be punishable under the Computer Fraud and Abuse Act of 1986.

   

Published by IACCM, 90 Grove Street, Ridgefield, CT 06877, USA www.iaccm.com