By George Gordon
Contract life-cycle management (CLM) could turn out to be one of the “most important new business applications of the first decade of the 21st Century,” according to Andrew Bartels, Forrester Research Inc. Technology is increasingly being applied to contract negotiation, execution and management to standardize, streamline and ensure contract and regulatory compliance and extend best practices and strategies for contract management across the organization.
Contracts are the foundation of any business. A typical Fortune 1000 company has 20,000 to 40,000 active contracts, each with pricing variables, service levels, and many other terms and conditions. The concept of viewing “contracts” as documents has segued into viewing “contracting” as a process.
Contracting is the beginning of the process to make sure that the right business partners are chosen, and the outcomes are properly managed and adjusted. All companies have some policies in the various stages of the contract lifecycle, from contract negotiation, to contract creation, legal review, execution, and finally the management and monitoring of the contract at any given time. These polices may be written and/or verbal. The processes enabling these policies may be manual or partially automated and located in various disparate systems. The effectiveness of these processes, which involve people and technology, are directly related to the success of your company.
Business Process Management (BPM) is an important concept to understand when implementing a CLM solution. BPM models human and machine tasks and the interaction between them as processes. It’s the what, why, where, who, and how business gets done.
Peter Fingar, a futurist and internationally recognized expert on business strategy, globalization and business process management, points out in connection with BPM: “It’s about the fusion of business operations and information technology to the point of unity. That transformation is well underway on a scale that can only be called the greatest 21st Century business reformation.”
If you are going to automate your company’s processes, it’s also time to review those processes and see where they can be enhanced. Put simply, optimize the way work gets done. Begin by asking questions like, How long does it take your company to negotiate and finalize a contract? How many people are involved? What are their levels of authority? Are they using preapproved templates and clauses?
Your company may have great processes, but is everyone actually following them? An automated process, with roles, permissions, security, and alerts helps ensure everyone is adhering to the process. An automated process can be audited in real time, and corrective measures can be taken.
One of the greatest values derived from BPM is gaining real-time information at the right moment so that the right decisions can be made while activities are still in progress—or before they occur. This is a critical step in contract management and where an integrated software application can be invaluable.
Today’s integrated software solutions are challenged to provide a flexible, scalable workflow engine with a workable architecture—one that is adaptable to the technology environment and usable by business managers. The architecture should be extensible and customizable on every level—for every process definition and at every process instance.
Most organizations have multiple departments writing contracts and following various contracting procedures. Many struggle with implementing a standard contracting process. A contract manager application can create boilerplate templates that help ensure consistent contract creation sanctioned by the organization’s legal department. It can instill contract governance rules so that each type of contract follows a pre-defined or dynamic workflow but always stays within the organization’s established conduct.
Visibility Across Departments
In many organizations, different departments or operations use similar services or suppliers—transportation, sourcing, etc.—where one department may have established contracts but the other lacks easy access to the contract without requiring additional work to copy and scan or mail the contract to the appropriate party. Studies show at least 10% of contracts are lost in many organizations. Visibility of contracts and other related documents is critical for the ability to monitor contracts, minimize corporate risk and achieve compliance. The ability for all departments to have visibility and access to contracts can increase the usage and adherence of some contracts since they can be easily searched and filtered by commodity, contract type, supplier name and many other options.
Certain key contract metrics need to be monitored, including automatic renewal dates and contract tolerances, such as spend amounts, minimum and/or limit quantities, pricing and other factors. In addition to expiring contracts, renewals and certificates of insurance, price adjustments and escalator clauses may also come into play and require monitoring.
And, the flip side of visibility is access control. If someone from another department requests access to a contract, who monitors that the person is cleared or approved to view that contract? Not everyone in an organization should require access to every type of contract. Online systems can include the ability to audit for compliance and establish numerous “roles” and privileges based on user level, department, organization, etc.
Contract approval and signature authority also should be tracked. Who is the next reviewer, and where is the contract—has it stalled unintentionally? Have others already approved, modified or accepted portions of the contract? Who has authority to accept, review or reject the contract? Is the contract current, expired or pending?
Control Maverick Spend
Visibility also helps avoid inadvertent and intentional “maverick spend.” It should be easy to determine if a contract exists, who the contracted suppliers are and what the contracted prices are. No longer are “I didn’t know we had a contract” or “I didn’t know I wasn’t supposed to do that” valid excuses.
The ability to share contract information across the enterprise enables employees to get the information they need quickly and do their jobs more efficiently. Inherently, maverick spend is reduced. Why? Because maverick spend usually occurs when employees can’t find the right information fast enough, so any route of purchasing is considered to get the goods and services in a timely manner. Best-in-class companies using CLM see higher contract compliance. Aberdeen Group, in an August 2008 report, notes that bestin- class companies see 86% of purchasing transactions compliant with contracts, versus only 7% compliance for laggard companies.
Contract management has to be viewed holistically, not just supply chain contracts, but all corporate contracts. Targeting supplier contracts is obvious. Vishal Patel of Aberdeen Group reported in “The Contract Management Benchmark Report: Procurement Contracts–Maximizing Compliance and Supply Performance” that nearly half of every dollar a company earns is spent on supplier contracts for goods and services.
Procurement’s priority is to procure goods and services in a timely and cost effective manner. Another equally important aspect of procurement is managing contracts for compliance. Being out of compliance can be very costly to companies in terms of unauthorized contract terms, contract leakage and regulatory penalties.
There are three categories of compliance:
When it comes to operational compliance, specific policies are integral to the success and control of the direction of the business. To maintain the standards necessary, the directives must be available, included in contracts and monitored. Standardization and policy are also positive tools for risk management and reduction.
Internal standardization of contracts and business processes, together with the internal visibility of the contracts to authorized personnel, will help ensure compliance with operational policies and procedures. A process with roles, permissions, security and alerts will help confirm that not only is everyone following the company’s internal policies and procedures, but they are following the same process.
Contract management provides tools to view and monitor internal policies and procedures and discover if the intended operational and financial results are being achieved. For example, have the internal policies and procedures really sped up the CLM time frames, or are there bottlenecks to be addressed? Have the appropriate revenue recognition clauses been inserted into the contracts, and has the company reaped the financial reward it intended?
There is organizational pressure to drive cost out of the supply chain while complying with internal and external policies, procedures and regulations. Procurement organizations believe that 70% of negotiated savings are actually realized. Chief financial officers view savings with only 35% realized.
It is crucial to know if the organization is buying from the right supplier, (i.e., the preferred supplier), at the right times, in the right quantities and at the right prices. Are your contracts being monitored to ensure suppliers aren’t overcharging or that all discounts are being applied? Have rebates been redeemed? If the contracts are not managed in real time, there will be “contract leakage.”
Has that supplier complied with its deadlines? Has the supplier complied with negotiated service levels? Is the company’s spend with that supplier in accordance with the contract terms and projections? When spend visibility is generated in real time, corrections and adjustments can be made in real time. New savings opportunities may be identified, and contracts may need to be renegotiated.
Every company faces evolving operational, environmental and financial regulations. While the alphabet soup of regulatory bodies (FERC, DOT, IRS, FDA) may vary, the current granddaddy of regulatory compliance applicable to all public companies is the Sarbanes Oxley Act of 2002 (SOX). Also known as the Public Company Accounting Reform and Investor Protection Act of 2002, SOX was enacted to improve corporate governance of American public companies after a series of corporate scandals and fraud in publicly held companies. The law was designed to protect investors by improving the reliability and accuracy of corporate disclosures required by the securities laws. It is one of the single most important changes in securities laws ever made.
Section 302 of SOX is the internal controls certification. It requires that the signing officers are personally responsible for establishing and maintaining internal controls and that the internal controls are designed to ensure that material financial information is made known to such officers. It holds them personally accountable for any financial misstatements. It requires continuous monitoring and reassessment of financial risks and controls to close any loopholes that could potentially lead to misstated financial statements. An automated contract management application can provide tools to periodically evaluate and test the effectiveness of the disclosure controls and processes. It also ensures the right persons are notified in a timely manner, through alerts, of the critical material information and that the notification is documented and available for audit.
Failure to comply may expose the company signing officers personally to harsh financial as well as criminal penalties. Executives convicted of violations of SOX, such as signing off on misleading or inaccurate financial statements, will be subject to fines up to $5 million and a sentence of up to 20 years.
Section 404 of SOX addresses the scope and sufficiency of internal controls. The company must report to the Securities and Exchange Commission (SEC) in its annual report management’s assessment of the quality and effectiveness of its internal controls over its financial reporting. The report covers the policies and procedures for maintaining accounting records, authorizing receipts and disbursements and safeguarding assets. The contracts of a company on both the buy-side and sell-side have significant effects on the financial reporting of a company. An automated application provides a single repository for all company contracts, making search and retrieval easy. Process changes and/or reassignment to different process owners can be shown through an audit trail and assist management in its assessment of the company’s internal control structure and procedures.
The complexities of SOX, urgent disclosure requirements, mandated certifications, personal accountability and civil and criminal penalties require the adoption of technology for a business to comply.
Studies have shown that for each dollar earned by an organization, as much as 80 cents can be lost to procurement costs. Coupled with the fact that most of those costs are external expenditures, typically governed by purchase agreements or contracts, the strategic importance of contracts becomes immediately apparent. Besides the dollars detailed in purchasing terms, there are also risks and liabilities tied to non-compliance with contract terms that could be extremely costly to an organization. These costs are especially damaging, as they can manifest long after a contract has been executed.
With all of this business-critical data contained within an organization’s contracts, it is clear that contracts are no longer just an administrative formality or strictly the domain of the legal department. There is significant and valuable data that is often buried within a contract document that can be extracted in real time to assist with contract compliance and provide real savings opportunities during renegotiation. More importantly, most of these savings gained through proper contract management are hard dollar savings due to rebates or supplier discounts. When there is no visibility into contract documents, money is literally being thrown away.
As spending categories have become more complex, so have the agreements. Agreements can contain terms governing such areas as charges, rebates, discounts, deadlines, penalties and more. Even more bluntly, these contracts determine how much a business gets paid (or, vice versa, how much it has to pay) and when. Surveys indicate approximately 67% of company revenues were based on contracts. Revenue leakage, estimated at 5% to 9% of revenues, was at the top of the list of concerns driving these organizations toward improved contract management. This is a significant percentage of revenue that businesses believe they are losing because they are not properly managing their contracts.
With increased visibility of contract terms, a company may discover sets of terms that are only applied to one type of agreement. There may be opportunities for further savings when these terms are applied to other types of contracts. Consider a $200 million spend agreement which offers a 10% discount on contract spend. Reducing maverick spend in this case by just 10% yields $2 million in real savings. Do such savings opportunities exist within your organization? Consider that spend analysis reports found only 42% of spending is visible at the contract level.
On the flip side is the issue of supplier compliance, that is, meeting certain targets or milestones to achieve a discount or rebate. A 2% discount on $100 million spend is $2 million of real dollar savings.
We can easily construct negative examples as well— that is, the failure to comply with contract terms. And, these are generally, in order of magnitude, more significant than the percentages associated with discounts and rebates. Failure to comply with legally binding terms may not only result in lost revenues from lost business but may also result in significant legal costs, damages and a tarnished image.
Contracts are strategic documents. Real dollars can be buried within the terms. Therefore, the concept of contract data visibility becomes critically important. If an organization wants to take advantage of the discounts and incentives detailed in contract terms and avoid penalties, people must be actively aware of what is contained within those terms. In fact, to reap the real benefits of contract management, an organization must be proactive. Data in the contract must be tightly linked to daily operations.
An organization’s proactive management of the creation, execution and analysis of its contracts will increase its financial and operational performance while reducing risks. Today’s highly competitive economy demands contract management become a core competency.
George Gordon is chairman and CEO of Enporion Inc., a supply chain management services company that provides strategic sourcing and e-procurement applications.