Money to Be Made Through Effective Contract Management
Purchasing is garnering increased attention from top management due to its substantial impact on profitability and supply chain performance. The purchasing process encompasses six key steps: specification, supplier selection, contracting, ordering, expediting, and follow-up. In this article, I delve deeper into the third step: contracting.
Once a supplier has been selected, the next stage involves drafting a contract. Approximately 70-80% of business transactions are formalised through contracts, yet they often slip from memory until issues arise. What should a contract cover? Vital components include price and terms of delivery, payment terms, penalty clauses, and other conditions.
Contracts can take various forms, including fixed-price contracts, fixed-price plus incentive fee contracts, cost-plus contracts, and cost-reimbursable contracts. Escalation clauses are also common to account for major cost adjustments due to external factors like fuel prices, currency exchange rates, and commodity prices.
Payment terms for capital goods, services, and works often involve multiple instalments, typically based on the supplier’s performance or deliverables met. In cases of advanced payments to suppliers, it’s advisable to secure a bank guarantee whereby the supplier commits to fulfilling their obligations.
Regarding goods delivery, contracts stipulate that deliveries must meet product specifications, be free from defects, and comply with relevant legal and governmental regulations. Penalty clauses based on performance guarantees, warranty periods, and end-of-life removal and collection responsibilities may also be included.
In international trade, essential commercial conditions are defined by incoterms. These terms clarify delivery responsibilities between buyers and sellers, encompassing transport, customs clearance, and transport-related risks. It’s crucial to expressly include incoterms in contracts rather than assume them.
In the public sector, public organisations may access a shared contract database, facilitating the utilisation of superior contracts, negotiation of new contracts with overlapping suppliers, and replication of existing contracts.
Lessons Learned
Following contract closure, a common issue is underutilisation or incorrect usage of contracts. Reasons vary from departments being unaware of existing contracts to contracts not meeting their needs or being rendered unusable.
Over time, many organisations find diminishing returns from existing contracts. Possible causes include poorly arranged contract responsibilities, lack of clarity regarding supplier duties, payments for underutilised services, and insufficient historical insight. Resistance to change, unmonitored supplier performance, delayed information, or unknown savings may perpetuate non-performing contracts within organisations.
Contracts may become outdated as needs evolve, suppliers falter, better deals emerge, or contracts expire or go missing. However, terminating contracts due to poor performance warrants caution, as another division within the company may re-engage the same supplier.
Effective contract management necessitates ongoing monitoring and active management in alignment with agreed terms. Notably, savings between 5 to 10 percent of purchasing value can be achieved through contract cataloguing and cleanup alone. In other words, there’s money to be made!
Dr. Marco Tieman
CEO, LBB International