Companies are doing a better job preventing value erosion in their contracts but for many organizations the process is still too inefficient to prevent losses, an analysis by World Commerce & Contracting and Deloitte finds.
Contract value erosion was 9.2% on average in 2014, when it was first looked at, considered a shocking amount at the time, says WCC, a nonprofit.
Losses are 8.6% on average today, still relatively high given the resources companies have poured into contract lifecycle management software and other ways to improve efficiency, says the report, The ROI of Contracting Excellence.
“Many … will feel that advances in technology should have provided a greater level of return,” the report says.
Contract value erosion takes many forms. It can be the imposition of penalty costs from a missed deadline or missed performance benchmark, or high renewal costs by letting a contract expire or lost savings through late payments. It can be unnecessarily high resource costs in preparing contracts by involving lawyers on a matter that could be prepared by a non-lawyer.
Investment in efficiency
Almost 80% of companies have invested in some type of contracting software in the last five years, and just within the last year almost 42% of companies have. But software can only solve part of the problem, the report says.
For one thing, contract data is typically spread throughout two dozen areas of an organization, making it difficult for people involved in the creation, negotiation or management of a contract to have visibility into factors that can minimize loss.
“The team developing a proposal for a new sales opportunity may have no access to existing performance data related to that customer,” the report says. “Information such as timeliness of payment or propensity for disagreements should be critical to assessments of risk and decisions over contract terms. This lack of data means that each new opportunity may be priced as though it is the first time it has been done, missing out on economies of learning.”
The complexity of contract language is a problem, too. Although companies have made progress in simplifying contract language, especially in consumer-facing contracts, overly legalistic language remains a barrier.
“Some 90% of business people find [contracts] difficult or impossible to understand,” the report says. “Many organizations are still having their contracts written by the equivalent of Latin speakers for an audience of English … native language speakers.”
Most value erosion doesn’t come from the details in individual contracts; it comes from inefficiencies built into the contracting process itself.
The report recommends segmenting contracts by complexity. Simple contracts that involve little or no negotiating should be handled one way and those that involve complex negotiations another.
Digital self-service capabilities, along with the use of clause libraries, are some of the ways to manage simple contracts efficiently, although right now most self-service capabilities are limited to non-disclosure agreements.
For more complex contracts, it helps to have the right people with the right training involved.
“Work is allocated to individuals without the necessary training or knowledge,” in organizations struggling with contracting efficiencies, the report says. “High-performing organizations have a clear understanding of the skills and knowledge required to develop, agree and manage their contracts portfolio.”
Each organization is different, but in general, healthcare, technology and logistics companies tend to be ahead of the game on contracting, and for many of these companies, value erosion is closer to 3% than the 8.6% erosion the analysis finds on average.
On the other end of the spectrum, law firms, retail companies and oil companies tend to have the most inefficient processes, putting their losses closer to 20%.
“Contracts will always suffer some level of value erosion,” the report says. “Unexpected disruptions, early termination, changes in requirements are some of the unavoidable and often unpredictable events that impact anticipated revenue, costs or savings.”
Given that contract data is spread over two dozen systems typically and about a quarter of employees at an organization play some role in the process, the key to limiting that erosion to closer to 3% is to look at contracting as a process and make workflow and system changes. That’s as important as the particulars of individual contracts, the report makes clear.