Best-in-class organizations regularly measure the performance of their contracts through internal metrics and against industry standards and leading practices. Robust contract management drives compliance, efficiency, and value through the utilization of key performance and financial metrics and effective implementation of controls across the lifecycle of the contract.
Managing leakages from third-party contracts (whether it is customer-side contracts or vendor-side contracts) is an ongoing challenge for most organizations. This is increasingly true in today’s business environment where improving margins and reducing costs are priorities. The likelihood of value leakage is higher in case of contracts with higher complexity (in terms of scope, commercial structure, risks and performance monitoring) and therefore these offer the best opportunity for savings. An ineffective contract lifecycle management may result in contract leakages (financial or non-financial) between 5% – 15% of contract value.
Understanding contract leakage and its root cause
Contract leakage can be defined as a gap (financial or non-financial) between the value captured or promised during the pre-award phase and the value delivered during or at the end of the contract. The value captured during the pre-award phase is often lost over time due to:
- Weak monitoring of contractual commitments and risks
- Lack of business case/value tracking and reporting
- Ineffective contract change control or administration procedures
- Scope creep and delivery and quality failures
- Bad planning and demand management
- Ill-informed buying
- Miscommunication and rigidity in managing the relationship
CXOs, business heads and procurement specialists should always look for key indicators that suggest the possibility of value leakages in contracts. The following are some indicators that have been seen in contracts as red flags:
- Lack of ownership or accountability over fulfilment of the contract or business case
- Ad-hoc or no tracking and reporting of contract performance
- Multiple variations or change orders
- Lack of understanding of commercial structure and scope of contract
- Contract compliances and risks being managed in silos or in an inconsistent manner
- Contract costs and schedule overruns
- Unsatisfactory stakeholders despite all performance indicators being met
- Long pending open issues and disputes
Consider an example: Management of a Fortune 500 company was facing difficulties with the operational performance of their large business process outsourcing contract – the internal stakeholders were unhappy and at the same time the cost of delivering those services had increased through multiple change orders/ amendments. They had lack of visibility on the fulfillment of contractual commitments and lacked the confidence of achieving the business case for outsourcing those services to a third party.
Management decided to conduct an independent study for assessing the current state of the contract. We evaluated the organization’s current contract and developed a review program that covers all aspects of the relationship – contract administration, performance, financial, compliance & risk and governance. A detailed study was conducted of the contract structure, terms and conditions, existing processes responsible for monitoring performance & compliance to contractual commitments.
The review identified instances of leakages across the lifecycle of the contract – ambiguous critical contract clauses , impact and reasons for change orders/ amendments not adequately reviewed before execution, service levels not properly baselined and monitored, financial commitments (investments, discounts/ rebates) and critical conditions of the contracts not being fulfilled by the vendor, invoices not adequately reviewed before processing, and penalties/ service credits not computed and adjusted.
The outcome of this study helped the management to identify control gaps in the contract management across people, process and technology and direct & tangible cost savings/ renegotiation opportunities. Together with the management, we strengthened the existing contract management processes, and built & implemented a robust/ consistent contract governance framework.
For organizations, there is no better way to assess the quality of the current state of contract management processes and systems than through an objective and independent study. This study can help organizations identify opportunities to achieve savings, recover costs and enhance value from their existing contracts (in addition to overall improvements to the contract management function across people, process and technology).