5 Best Practices Toward Contract Compliance

Sept. 16, 2009
Companies lose nearly 3-5% of savings opportunities because of auto-renewing evergreen contracts.

Operational efficiency is imperative during a recession. Without question, it's become critical for organizations of all sizes in the past twelve months to eliminate unnecessary costs and increase financial transparency. And over the coming year, procurement leaders will need to balance the need to further streamline their operations. For many companies, contract management will prove the key that brings together operational efficiency and savings compliance.

Organizations need to consolidate contracts across their enterprise. One of the primary goals of procurement professionals must be to close process gaps, ensuring visibility to all contractual and non-contractual spend. Best-in-class organizations achieve up to 80% more savings than others through a clearly defined contract compliance process. (Source: Aberdeen Research)

The core of an effective contract management program is a central repository for holding contracts. Yet only 48% of organizations have a central repository to manage their contracts, according to a recent Aberdeen Group report.

Why does this matter? Contract compliance helps to provide guidance and insight into procurement processes and helps to achieve savings through better negotiations with suppliers. For example, companies lose nearly 3-5% of savings opportunities because of auto-renewing evergreen contracts.

According to the Aberdeen Group report "Procurement Contracts, Real Value, Real Returns" nearly "77% of all enterprises stressed the efficient management of procurement contracts to achieve savings in this downturn."

"Best-in-class organizations are 43% more likely to hold contracts in a central repository and place almost 82% of their contracts in these repositories." (Aberdeen Group Research, March 2009)

This article shares industry best practices for contract management, including how the right automation approaches can enable companies to achieve contract compliance while helping drive further savings opportunity identification.

Create dynamic contract repositories that reflect operational requirements

  • Define, communicate and effectively manage to specified contract metrics.
  • Institute regular contract audits and apply learning to turn them into opportunities.
  • Standardize and accelerate contract authoring by maintaining a template and clause library
  • Create a standard workflow for collaborative authoring and negotiation of contracts

1. Create Dynamic Contract Repositories that Reflect Operational Requirements

Contract Negotiations Driven by Dynamic Markets

Contract negotiations are one of the many ways that companies can leverage savings opportunities.

Given today's highly volatile currency and commodity market environments, organizations need to identify savings opportunities that can take advantage of market conditions versus sacrificing savings to them.

Tracking Global Contracts is a Major Challenge

Many companies involved in global -- and even regional -- contracting observe that it is difficult to increase their visibility into contract exposure around multiple currencies and commodities. Because procurement organizations often denote contracts in both local currency and the dollar it is often difficult to track specific exposures.

Moreover, currency fluctuations may result in companies overpaying and losing out on considerable savings. Companies should track contracts dealing with volatile commodities as massive price fluctuations may provide opportunities for savings(e.g., the price of steel sheet or copper coil can vary by 8% or more on a single day in different regional markets). However, the good news is that companies can effectively manage this volatility provided they have visibility into underlying market indices combined with escalator and de-escalator clauses in the contract.

Let's review the following scenario.

Company ABC negotiates an annual transport contract with a contract rate of $100,000. The contract is linked to volatility in fuel prices by the provision of escalator/de-escalator clauses. ABC now establishes a reference price. The reference price may be the price of oil on an agreed upon commodity index. The minimum change for which the clauses become effective is set at $15.

The clause states that the change in contract price is = 30% of original contract rate X (change in oil price / reference price)

Now, if the price of oil on the index falls from a reference price of $135 in July 2008 to $56 in May 2009.

The change in the contract rate for the given change in oil prices would be = 0.30 x 100,000. x ((135-56)/135) =$17,555.

The new contract rate generates a saving of 17.6%. Of course, this is a simplified example and the clause contains several caps and conditions. But it shows how simple it is to identify the potential savings of linking contracts to commodity indices. In addition, the company could define automated alerts within their contract management system based on variances of any pre-defined amount (For this example: $15).

Best Practices

  • Include escalation and de-escalation clauses during contract negotiation and link these to market parameters like foreign exchange & commodity indices.
  • Set a system of alerts and reminders for the specific escalator/de-escalator clauses linked to commodity or Forex indices.
  • Track and measure compliance and quantify the savings accrued from these contracts when possible.

2. Define, Communicate and Effectively Manage to Specified Contract Metrics

Transparent Measures for Contract Compliance are Essential

Many industry experts argue that it is necessary for companies to put in place quantifiable contract compliance performance metrics across their organization to achieve the types of savings opportunities that best-in-class organizations realize on a daily basis. Having quantifiable measurements for contract compliance also helps to identify underperforming segments.

Matching Spend Data to Contracts -- A Tedious Endeavor

Most companies progressing through the contract management journey realize at some point that establishing performance metrics is often easier said than done and matching spend data to contracts is the biggest hurdle. Our experience suggests that the secret to overcoming these challenges is process automation.

Best Practices

  • Link contracts to spend to establish performance metrics
  • Establish benchmark parameters with regards to peers
  • Communicate and elicit input from decision makers while determining parameters.
  • Track contract compliance and utilization based on these parameters

3. Institute Regular Contract Audits and Apply Learning to Create Opportunities

Identify the Source of Non-compliance

It is one thing to proactively identify opportunities during the contracting process. But it is another to capture lost savings opportunities after the fact. Our experience suggests that vendor overpayment is one of the most common forms of non-compliance. These mistakes, often innocuous (e.g., clerical errors) can sometimes point to vendor or internal fraud (recent case of Best Buy). In case of non-fraud situations, one of the most common errors is purchases made without keeping track of volume or other discounts negotiated in the contract.

Disparate data: A major road block to efficient auditing

For most companies, consolidation of contract data across different geographies and disparate formats is a roadblock in performing an efficient and thorough audit of internal contracts and trading partner relationships.

"Approximately 50% of companies admitted to having poor visibility into their supplier contracts, making it difficult to track and monitor them. A key reason is that 80% of these companies are using manual or partially automated processes and disparate systems." (Aberdeen Group Research)

Companies must also identify a number of other critical areas to improve visibility based on spend, size and industry profiles.

Best Practices

Increase visibility by developing the necessary infrastructure and organizational commitment to ensure contract compliance. Visibility should be improved in the following areas:

  • Currency Change and Conversion
  • Cost Amortization
  • Volume Discounts
  • Buyer Turnover
  • Clerical Errors

4. Standardize and Accelerate Contract Authoring by Maintaining a Contract Template and Clause Library

Standardized Contract Creation = Faster Contract Creation

Long drawn out contract authoring leads to undue delays in negotiation cycles. Standard, well- defined templates for contract authoring can help lower compliance violation and other associated risks.

"Best-in-class enterprises reduce contract creation time by nearly 15-20% compared to others by standardizing contract language." (Aberdeen Group Research 2009)

Standardizing is a Continuous Process

When organizations implement standardized templates, they realize that such an approach can create challenges during amendment of agreements. This can be particularly nagging during the preparation of customized contracts. Our research suggests that regular updating of templates and clauses for any changes due to regulations, processes or industry measures must be an activity that companies manage with extreme care under the guidance of domain experts on a continuous basis.

Best Practices

  • Define mandatory/non mandatory clauses
  • Define templates and clauses based on geographies and categories
  • Ensure continuous updates to all clauses and access to relevant stakeholders to modify and maintain templates

5. Create a Standard Workflow for Collaborative Authoring and Negotiation of Contracts

Standardized Workflow is the Key

Faster contract authoring and approval can be achieved easily by establishing a standard workflow for creating, amending and approving contracts. Workflow standardization is essential to reduce contract creation cycles and ensure stakeholder improvement. This also helps eliminate ambiguity in the contract authoring process.

Bringing Together Contract Stakeholders is Essential

Gathering feedback and support from all stakeholders in the contracting process is never easy. But achieving such a collaborative model can help streamline contract amending and approval.

Best Practices

  • Create a standard workflow with set protocols and procedures
  • Define hierarchies for approval process
  • Ensure access to all necessary stakeholders during the contract authoring and amendment process

James Thomas is in Product Marketing at Zycus. Zycus provides Spend Management Solutions that help Global 1000 companies implement best practices in their organizations that drive maximum user adoption, reduced cycle time and sustainable savings. http://www.zycus.com/

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