Monday, March 19, 2012

Contracting strategies

What is a “contracting strategy”? In managing contracts for a corporation each entity may have their own contracting strategies. Sales may have their sales contracting strategies for their sales contracts. Procurement may have their contracting strategies. Service organizations may have their strategies. Leasing or licensing organizations may have their own strategies. The term “Contracting Strategy” can have a variety of different meanings. For this post,the contracting strategies I’ll discuss are various procurement contracting strategies. If you can think of ones that I’ve missed please feel free to add it through comments to this post..

A contract strategy in procurement:
Can be used to identify which purchases you have under contracts versus simply P.O.'s.
Can mean decisions on how you source (single suppliers versus multiple suppliers).
Can be a method by which you hedge certain procurement risks.
Can describe what risks you are willing to accept and what you want to transfer to the other party.
Can describe how you plan on writing agreements (fixed term, self extending, evergreen).
Can address how you manage things like end of life or end of support.
Can refer to a strategy used to manage when contract negotiations will occur.
Can be driven by perceived leverage changes that may occur between the parties.
Can represent a strategy for the establishment of standard contract templates, alternative clauses and what individuals may change or need to get approved on to changes is part of an overall contracting strategy.
Can also vary depending upon the life cycle of a product or service you are buying.

Contracting strategies are driven by the need to manage risk. They may be driven by the desire to take advantage of opportunities both now and in the future. They may also be driven by resource availability that’s needed to manage the activity. There is no one single best strategy and within a company you can easily have different strategies employed in different commodities. Let’s take a look at these and more,

1.Strategy on which purchases you have under contracts versus simply using Purchase Orders. There are three major factors that decide this. One is the potential to leverage repetitive purchases or the same items or from the same suppliers to simply get a better deal. The second factor is the inherent risk with the purchase. The third factor is the risk or impact of a failed performance. Small dollar value items may high risk and high dollar value purchases may be low risk. Low risk, not repetitive purchases should be done by purchase orders. Low risk repetitive purchases should be put under contract when better pricing or terms can be achieved. Higher risk non-repetitive purchases should as a minimum have a written or electronic acceptance so it is a binding agreement. Higher risk repetitive purchases should be under a contract. All high risk purchases should be under a contract

2.Contract strategies on how you source. If you have a single source supplier that you are dependent upon where the cost or time to switch suppliers is prohibitive, you should always have a contract and the contract needs to protect you. For single source contracts the term should be for as long as you potentially need the supply or services. You should have price and other competitive protections built into the contract. For example if you committed to purchase all of your requirements of a particular item from one supplier, to maintain that commitment you would need them to meet all performance requirements set forth in your contract. You would want them to commit to provide you with all of your demand. You would also want to require that supplier be competitive from a price and technology perspective with other companies and have the ability to benchmark other companies to force the supplier to remain competitive. If you have multiple suppliers that are under contract and are qualified to perform you would want a contract strategy where contract expire on alternative years. That way if you are not able to successful renew the agreement with one, you have the other and also have a year to bring on an alternative. I might also include a transition period, where if there is no agreement on the contract, the supplier agrees to sell you products or services for a limited term at the same price and terms that existed to smooth the transition.

3.It can be a method by which you hedge certain procurement risks. For example in true commodity markets your contract strategy could be a mix of contracts and spot purchasing. The contracted purchases provide stability in pricing and the spot purchases provide the ability to take advantage of spot rates when they are favorable and not be too hurt when they are unfavorable as the contract purchases mitigate the impact.

4.It can identify which risks you are willing to assume, the type of contract you want to enter and what risks you need to transfer. There are a number of approaches to contracts starting with time and materials and ending with a fixed fee. The variables between approaches are time versus risk. A contract strategy should help determine what the best approach is for an individual situation

5.If can describe how you plan on writing agreements (fixed term, self extending, evergreen). In determining the length of the agreement there are several things to consider. The first is how long do you expect the relationship to last. Second is how much do you think the contract terms will change. If you expect that it will be a long term relationship and the primary things that will change will be the addition or removal of products or service and changes to the prices or lead-times, you can do a long term or self-extending agreement in which you periodically have the right to negotiate those changes. That eliminates the need for managing amendments to extend the contract term. When you select a fixed term you always need to be concerned with having to manage extensions or have sufficient advance notice that you may need to source an alternative. For example, if I had a two-year term and I know that it would take 6 months to qualify and be in the queue to get materials, I would want the negotiation of any extension with the existing supplier to occur before the eighteen months had passed so I could plan accordingly.

6.It can address how you manage things like end of life or end of support. Every product has a point in time where it is no longer manufactured, having been replaced with a newer or better one. No product is committed to be supported forever. There will always be a time when the supplier declares that they will no longer supplier that product or that version. The contracting strategy needs to take both of those into account and establish what’s required to deal with those situations. It can be things like requiring guaranteed availability for a certain period. It can include things like advance notice to identify other alternatives and last time buy options to provide a smooth transition.

7.It can refer to a strategy used to manage when contract negotiations will occur. In many companies price negotiations need to occur at the same time every year to establish standard prices for planning purposes for the next year. Where groups get into problems is when they also try to do contract negotiations at the same time. The two do not have to be managed together and when you use term contracts that need to be re-negotiated its best to establish a contract strategy to have contract term expiration dates be spread over the course of the year, with the option to adjust pricing when that is negotiated. For example, if you had a contract had the price negotiated in December where the price was good for a year and the contract expired in June you would extend the contract in June with the pricing previously agreed with the agreement that new pricing would be negotiated in December of that year.

8.It can be driven by perceived leverage changes that may occur between the parties. For example, if you agree to a single source situation with a supplier, at the end of the initial contract term your leverage may be limited if it is difficult or costly to change suppliers. If you find yourself in that situation you need to have a strategy that implements either a longer term agreement or you need a contract where you have an option to extend the agreement and only limited parameters are subject to negotiation and those are also bound by other parameters. For example, they only thing subject to negotiation is the price and the future price cannot be more than X percent over the current price.

9.The establishment of standard contract templates, alternative clauses and what individuals may change or need to get approved on to changes is part of an overall contracting strategy. This is clearly part of managing risks to ensure that the right level of skill has to be involved in changes that could significantly impact the cost or risk of the purchase.

10.The contract strategy may also vary depending upon the life cycle of a product or service you are buying. For example during the initial phase of a product’s life the price is usually the highest it will be and will go down as competition enters into the market. So in this initial phase you would want long-term contracts that lock you into a price that will be falling. At the end of the life cycle of a product as companies exit the market with demand still remaining, prices tend to go up so if you renewed a contract when the market was at its low point you would want a longer term contract to protect you against that price upswing that normally occurs.

11.Contract strategy should take into account and manage when contracts expire to avoid expiration during key periods. When I worked for a bank management wanted to replace their debit card processor with a new supplier. The problem was their current contract expired in December, which was their most critical period of the year. The risk in changing suppliers at that time was simply too high to risk it. So I approach the supplier in the end of September and negotiated a three-month extension to the end of March. That was to allow for negotiations with them and others. They didn’t keep the business and we were able to switch over to a new supplier performing the conversion to the new supplier at a far less critical time. Contracts don’t need to have terms written only in annual increments. You should have a strategy that allows you to set a contract term’s length so that it will expire when it is best for you to have it expire.

12.Contracting strategy can also look at how customers decide to use prime contractors or interact with subcontractors, especially subcontractors that are critical to them where they may need long term relationships.

The key in developing contracting strategies is to always be thinking in about two things. First, what are the circumstances and what do you need at the time you need to negotiate the agreement. Second, what do you perceive will occur over the term of the agreement and how to you want to manage, control, or take advantage of that. President John F. Kennedy provided a great contracting strategy when he said "The time to fix a roof is when it's sunny."


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1 comment:

  1. The color of your blog is quite great. i would love to have those colors too on my blog.:`-.: contracting a supplier

    ReplyDelete