Dealing With Contract Risks

Negotiating a good deal is an essential aspect of procurement, but it's easy to oversimplify negotiations as only a matter of getting the best price from a supplier.

While the primary objective of a negotiation may be to purchase a quantity of a certain part at a particular price, other issues should be examined carefully. For example, you might find a supplier who offers a very low price but, on further investigation, turns out to be employing illegal labor or using potentially harmful materials in its product. Those unintended consequences of a seemingly simple transaction can be extremely damaging to a company's reputation and its bottom line.

According to Dave Zechnich, a partner with Deloitte, it's important to enter a negotiation understanding two things -- what is your business objective and what are the risks that could prevent you from achieving those objectives.

"The whole point of a negotiation is to make sure you have a meeting of the minds of the two parties to make sure expectations are clear. This is why we are both in this relationship. This is what we are both going to get from it," says Zechnich. "The purpose of the contract is merely to embody those expectations."

To help understand fully business objectives and provide a way to ensure they are met on an ongoing basis, Zechnich advocates companies establish a contract risk and compliance (CRC) program. A solid CRC program can clarify the goals and expectations of both parties, specify service levels and monitoring processes, establish appropriate disclosure and information sharing, and help organizations to perform as specified.

"Implementation of the deal and continued monitoring is incredibly important," says Zechnich. He notes that the people who negotiate a deal are not necessarily those who will be "living the deal." And, he adds, it's natural to expect that over time, things concerning the deal will change or appear to change. For example, a company may hear rumors that its distributor in a certain area is expanding into territories where it does not have contractual rights. By creating a mechanism for monitoring the contract, the truth can easily be established. "If you occasionally validate what they are doing with your product, you can know that that isn't true. Those things don't erode the relationship and you can have a great long-term relationship," Zechnich says.

As part of the monitoring, he says contracts should include some sort of governance structure that provides for ongoing communication between the two parties. And in most cases, says Zechnich, companies are wise to incorporate an audit clause in their contracts that is applicable to the relevant risks. A company with a fixed price contract, for example, may want to audit a supplier's controls for protecting confidential information but has no need to audit pricing.

Because companies typically have expanded their supply chains and use of contracting, Zechnich observes, audits are becoming more commonplace as a way for companies to increase visibility into their extended enterprises. He said companies also increasingly are recognizing the risks that more complex supply chains pose and he noted an increased demand for "complete evaluations" of the risks in their supply chains.

In an environment where purchasing officials are fielding increased demands from top management for price concessions, Zechnich says a CRC program can help parties continue to seek win-win relationships. "Each party should make sure they understand what the objectives of entering the relationship are and if each party does that honestly, and expresses what they are trying to achieve, you get a win-win," he says, "particularly if they are thinking ahead to governance structures, implementation and continuing monitoring."

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