Enabling Incentive Based Contracting

The growth in cloud and infrastructure technologies has given companies the ability to store, analyse and make decisions using advanced tools and drawing from huge data lakes. As emerging businesses enter their respective marketplaces, they are no longer needing to be digitally transformed as they are already digitally enabled. This gives them the edge in building scalable business systems, processes and infrastructure to support their operations.

 

There has been little development, however, in the way companies’ contract and price their goods and services. There are innovative mechanisms available, such as Incentive Based Contracting which has been in use in the MOD since the 1960s, but such contracts are typically very complex to manage with onerous contract frameworks, the burden of maintaining financial models and the need to report against delivery of requirements.

 

There has been some application with varying results across the public sector; Open Book and Incentive Based Contracts are commonplace for large defence, nuclear and construction contracts. Due to the highly regulated and safety-critical nature of these markets, notwithstanding the huge physical and financial risks, business operations are arranged so to collect and retain granular operational and financial data. This data then provides a ready-made platform for the operation of more complex contracting models which rely on transparency of such data.

 

Incentive Based Contracting rewards the Supplier for delivering measurable outcomes e.g. performance improvements or total cost of ownership (TCO) reduction. It provides a commercial and contractual framework where relationships are vested. This paves the way for effective commercial management and operations, stimulating partnered behaviours and driving future innovation.

 

To implement, Incentive Based Contracting requires skilled staff, accurate cost collection systems and appropriate contracting vehicles. In order to accurately track value metrics, businesses should look to leverage available technologies allowing them to accurately shape and manage contracts, and in turn develop their infrastructure to accurately share and optimise costing data. This facilitates extant contract management and has the benefit of also informing future contracts in the context of pricing.

 

Oft-quoted is the saying, “buyers are searching for the hole not the hammer and nail”. Both parties should strive for a culture of mutual trust, and be willing to share information in a transparent manner; getting to know their business partner as truly understanding their objectives is a much more effective basis for contracting.

 

The days of locking a contract in the drawer are over. We believe that there will be a rise in transparent Incentive-Based Contracts as critical commercial information becomes easier to store, analyse, validate and share.

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Athena Commercial December 13, 2019 0 Comments

Understanding Contract Price Type

Whether you are on the customer or supplier side, contract price types can often be misunderstood and not used to their full potential. It is important to understand the context of the engagement you are looking to contract, and the most appropriate price type to manage risk and incentivise performance.

It is also essential that your contract model allows for agility and change, as requirements / solutions and delivery environments change often, and the contract needs a workable mechanism to deliver fast, effective change without stifling performance and innovation.

Your contract price type is a key area of negotiation, both from a commercial contracts and pricing perspective. Without a clear view of the allowable costs within an open book model, suppliers run the risk of either not pricing all of their required costs, or under pricing and having to fund the delivery of contractual obligations.

There are a broad range of price types within contracts, and whilst this isn’t an exhaustive list it should give an overview of the most common contract price types and the best areas to use them.

  • Time and Materials

T&M contracts are often used where requirements and outcomes are not accurately defined, and where a task is considered more “open ended” than a traditional specification-based model. Under T&M, the Contract Price is based on the actual cost of direct labour, materials and overheads. In this arrangement, direct labour is typically charged at hours/days x agreed rates plus the actual costs of materials and equipment usage. Then their may either be an agreed upon uplift to cover overheads and profits, or the contractor will accommodate this uplift within its charging rates.

A perceived advantage of the T&M model is that its flexibility is a benefit, and it is a mechanism for “getting stuff done” whilst providing the opportunity and ability to adjust requirements and shift direction. In reality, this flexibility can just as easily be implemented in a well written contract, and from a customer perspective T&M contracts present a risk as they can sometimes lead to poor requirements definition and poor design. It is always advisable to define the projects outputs beforehand. If T&M contracting is the right fit for your project, then it is recommended that you include a cap mechanism to ensure you are aware of your Not to Exceed position.

  • Firm Price & Fixed Price

There is a lot of confusion in different industries and countries regarding the terminology Fixed and Firm Price, and the two are often used interchangeably with different understandings of the definition. For the purpose of this blog we will use the UK government definitions where:

  • “Firm Price” – The Contractor undertakes the Contract for a total, all-inclusive price that will not change.
  • “Fixed Price” – The Contractor undertakes the initial period of the Contract for a total, all-inclusive price that will not change. However, elements of the price may be varied after an agreed period using an agreed mechanism”

Therefore, a Firm Price contract is where the price is set and fixed (and adjustments do not apply). The only mechanism for changing the Contract Price would be through an agreed change control. Whereas a Fixed Price Contract is where the price is set and fixed, however adjustments can be applied in allowable circumstances as defined within the contract.

The main difference between the two is whether adjustments are contracted and there is a mechanism to treat these in the contract (such as inflation). As stated above the actual definition may vary dependent on your environment, so it is advised that you always understand the adjustments position contractually, regardless of your familiarity with pricing terminology. Where inflation is being contracted, it is always worth ensuring the agreed economic adjustment is appropriate for the context of your industry (see https://www.ons.gov.uk/economy/inflationandpriceindices) regardless of whether reviewing from supplier or customer side.

More generally, you should use fixed price contracts where the requirements and programme plan are clear, where there is a limited or fixed budget, or where there is a small project with limited project scope. Ultimately under a fixed/ firm price model the majority of risk lies with the contractor (who should price that risk accordingly). For more effective contracting it is recommended that risk lies where it is best controlled, and there is an appropriate commercial mechanism within the contract to treat this.

  • Cost Plus Incentive Fee

Cost Plus Incentive Fee contracts are an advanced contract mechanism which require good commercial management skills and behaviours from both supplier and customers. This is an open book contract and when operated correctly, Cost Plus Incentive Fee contracts can lead to a better relationship between buyer and seller (because good performance and working together is rewarded) and enhance communication lines between parties as performance criteria will be accurately monitored.

Cost Plus Incentive Fee contracts consist of a base contractual fee (note, this can sometimes be zero, or may be zero until achievement of Gateway Service Levels) and an award fee determined by the achievement of specific milestones (or outcomes) as defined by the contract. This type of contractual arrangement allows the Supplier to be reimbursed for the costs of performing work and provides an incentive for the supplier to deliver excellent performance in accordance with the performance criteria stated in the contract. If the performance of the contract is at a lower threshold than expected, then the fee should be adjusted proportionately.

A more sophisticated application of this mechanism (and TCIC) would be where the outcomes / performance criteria are directly mapped to the customers budget position through conducting detailed analysis of the customers operating model and Target Operating Model. Performance Criteria can then be contracted and tracked against the actual quantifiable benefits delivered back to the customer.

  • Target Cost Incentive Fee

Again, an open book contract, the Target Cost Incentive Fee (TCIF) mechanism is similar to a Cost-Plus Incentive Fee contract price type, however in a TCIF the performance criteria is often focused around cost reduction. It is a powerful mechanism for incentivising cost reduction and supplier performance. Increased fee levels are often paid to the Supplier on achievement of cost savings, and typically a “Gain-Share” ratio is applied. The share between the parties is dependent on the agreed negotiated positions of the respective parties.

On larger multi line multi year contracts, to ensure effective change management it is essential to have a robust cost / price baseline via your Contract Financial Model against which any change can be impacted. It is also recommended a similar level of discipline is applied to requirements to solution mapping to ensure a stable design / programme plan.

In UK Government, TCIF contracts are typically contracted as a MTCP (Maximum Price Target Cost) which caps the customers liability and means any cost overrun will fall to the contractor. Whilst principles can vary across price types, often in the Private Sector the terminology GMP (Guaranteed Maximum Price) is used, which is where the Supplier is compensated for actual costs, and the fee mechanism can vary from Fixed Fee, Incentive Fee or a Gain-Share mechanism.

  • Cost Plus Fixed Fee

A cost-plus fixed fee contract price type is again an open book contract, however under this arrangement to contractor is reimbursed allowable costs (as defined within the contract) and paid a fixed fee for delivery. This is more appropriate for more transactional type contracting arrangements where output-based performance criteria are either already optimised via different mechanisms or where they are hard to define.

To learn more about Open Book Contracting, see https://www.commercial-consulting.co.uk/open-book-contracting.

If you have any further questions on price types, or require specific advice on a project, please contact us at info@commercial-consulting.co.uk.

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Athena Commercial November 7, 2019 0 Comments

The 9 Benefits of Contract Management Software:

The 9 Benefits of Contract Management Software that deliver real value:

 

IACCM (The International Association of Commercial Contract Management) research has found that 70-75% of failing projects occur due to contracting and commercial issues, resulting in an average of 9.2% revenue leakages. https://www.iaccm.com/news/contractingexcellence/print/?newsletterid=82. Therefore, commercial management and commercial control are essential, and organisations are quickly realising the business relevance and business value to implementing and operating Contract Management Software, with more and more successful implementation showcasing the high impact it has on business including improving effectiveness, efficiency and productivity of operations.

In today’s digitally connected world keeping contracts in the filing cabinet is archaic, and businesses are understanding why Sharepoint and File Drives are also not the optimum solution to storing you contracts properly . In Gartner’s December 2018 Market Guide for Contract Lifecycle Management (https://www.gartner.com/en/documents/3895881/market-guide-for-contract-life-cycle-management), it states:

“Document management systems and shared drives don’t support contract reporting and analytics. Without contract analytics, organizations cannot manage workloads, performance and compliance”.

Contract Management Software also contributes to risk mitigation and performance maximisation, ensuing stakeholders are aware of their obligations and communications are seamless regarding renewals, payments, extensions, contract performance etc. Therefore organisations are rapidly implementing Contract Management Software to streamline their operations and free up the time of Contract Managers to focus on more value- add activity such as commercial negotiations, supplier performance management and commercial optimisation.

The Top 9 benefits of Contract Management Software are:

 

1.) Makes Commercial Management a Priority

Implementing a Contract Management System generates a renewed focus on your commercial processes and contract documentation, creating momentum within your internal Commercial / Procurement teams, and delivering outputs to internal business stakeholders, suppliers and your customers giving you organisational tempo to deliver fast and impactful changes.

 

2.) Discover your Contracts

During the discovery and implementation phase of your Contract Management Software, our team will work with your business to identify, locate and store your customer and supplier contract. This means that through the activity you can stabilise your contracts portfolio and ensure that your data collection is complete and accurate. Your contracts will then be stored in a cloud-based contract repository allowing you to access contract information, stakeholders and files within a few clicks.

 

3.) Upload and Understand

During the implementation phase, we will migrate all your contracts onto our Contract Management platform, including populating the tool with key commercial information such as contract price, contract term, liabilities and termination clauses and much more. This delivers you contract analysis as well as delivering on the contract implementation phase, resulting in an improved contract management approach for your business, and acting as an independent contractual review which can highlight improvements.

 

4.) Renewals Management

Our system can set up renewal notifications to ensure the right people are made aware when contracts are expiring. You set the parameters, whether 30,60,90 days before end date, or you can set a custom period. This will help minimise cost increases as a result of automatic renewals and ensure you are organised and in control of both your supplier and customer renewals, keeping your pipeline moving and ensuring your suppliers are delivering value for money.

 

5.) Enhance Commercial Processes

Working through a Contract Management implementation allows for a robust review of your existing processes and allows us to providing consulting including advising on best practice and lessons learned from other clients to optimise your processes and deliver business value to your internal customers. Implementing Contract Management Software also aids how business processes and functions work, giving you definition of the necessary mechanisms, inputs and outputs and helping identify and deliver organisational objectives.

 

6.) Segment your Customers

Contract Management Software is the first step to having a robust analytics capability within your organisation and our solution allows for customer segmentation, allowing you to understand what you are selling and where and in which verticals. You can see which contracts are associated with which customers, enabling you to explore consolidation opportunities which serve in both yours and your customers best interests.

 

7.) Track your Suppliers

Just as important as the customer position is the supply chain, and Contract Management solutions enable the collection and cleaning of data, allowing you to structure and develop a robust and exploitable analytics capability for your supply chain, allowing for effective procurement categorisation and enabling true supplier performance management.

 

8.) Informed Spend Analytics

Our platform allows for effective Spend Analytics, allowing you to truly manage the fixed and variable costs of your direct and indirect suppliers, and using this data to identify improvements and inform business decisions. You can look for consolidation opportunities and use this data to inform your overarching procurement strategy.

 

9.) Audit & Compliance

Our solution allows you to store and examine contracts digitally in one place, allowing for enhanced visibility and making finding contracts and contract information much easier. This not only increases productivity, freeing up resource for more productive things, but it also supports regulatory and contractual compliance, informing other business processes and delivering streamlined contract accountability. This is crucial to ensure you prevent financial, operational or reputational loss & risk.

 

We hope you find these benefits useful, and please contact us at info@commercial-consulting.co.uk to learn more.

Our Contract Management migrations are simple, fast and effective. We target 1 month from Contract Signature to Go-Live, delivering you increased commercial control, cost savings and streamlined business processes that are the right fit and easy to implement.

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Athena Commercial November 4, 2019 0 Comments

Benefits of Open Book Pricing & Contracting

“Re-establish good faith, give the estimation of the work and not refuse a reasonable payment to a contractor who will fulfil his obligations. That will always be the best transaction you will be able to find.” Marshal Vauban (1633 – 1707), Chief of Fortifications for Louis XIV, writing in 1683

Open Book Contracting is a commercial and procurement model which advocates transparency between clients and contractors. It is driven by the open and timely sharing of information to ensure that operational, commercial and programme decisions are taken in the best interests of both parties to enable delivery of both parties’ obligations to meet the desired outcomes of the contract. It enables the appropriate transfer of risk and can be used to financially (or otherwise) incentivise suppliers around key business drivers and TCO reduction targets.

In order for an Open Book Contract to truly work, all engaged parties (including, where necessary supply chain partners) must be commercially mature enough to see past the initial perceived risks associated with sharing pricing information, and efforts should be undertaken to ensure all parties understand the strategic objectives and commercial process associated with developing the price, solution and delivery programme. The core principle of Open Book Pricing is transparency, and many companies have reservations about adopting a transparent philosophy in the way that they develop pricing for their clients. Our opinion is that Open Book pricing is one of the few ways in which all parties can truly understand each other’s obligations, and one of the key benefits of Open Book Pricing is that it drives a philosophy and thought process which enables “bottom up” thinking and the sharing of key information between parties. This enables the resulting Open Book Contract to be structured in a flexible and agile manner to accommodate any anticipated risks or changes.

General Benefits of Open Book

  1. Partnered contracting models allow for “bottom up” thinking, which allow all parties to understand each other’s constraints, obligations and considerations in order to make effective commercial and operational decisions on behalf of the partnership.
  2. Open Book Pricing allows for the true understanding of the costs of the products or services and enables effective decisions to be made regarding the true Total Cost of Ownership (TCO).
  3. Open Book Pricing and contracting allows for the partnership to truly understand each other’s commercial and operational performance drivers, allowing for an effective contract to be structured to facilitate the desired outcomes.

Benefits of Open Book Pricing / Contracting for Suppliers

  1. Open Book Pricing encourages a granular and bottom up estimating methodology, which affords suppliers the opportunity to fully cost both their obligations and solution.
  2. Open Book Pricing enable transparent information sharing between parties, which allows for price variances to be modelled upon the provision of updated or revised information.
  3. Open Book allows Suppliers to discover the client’s true business drivers, increasing customer engagement and enabling the development of a true value proposition back to the customer
  4. Open Book Pricing opens the door for incentive based contracting mechanisms, including Maximum Pricing and Target Cost Incentive Fee (TCIF) commercial models.
  5. Allows for risk sharing protocols to be determined, enabling the commercial model to be structured to anticipate, mitigate and treat commercial, programmatic and operational risk and ensure that risk is attributed where it is best managed.
  6. Open Book principles build trust with customers and suppliers, especially when the processes and principles are structured cognisant of the interests of both parties.
  7. Supports the development of effective change management governance and functions, and the associated financial baseline to adjust charges where appropriate.
  8. Open Book contracts can sometimes be more profitable than traditional “fixed price” engagements, especially where profit is linked to stretch performance targets (i.e. gain share on reduction in TCO spend).
  9. Open Book contracts drive internal operational and commercial discipline, and “gear up” organisational behaviour and contract management to truly meet customer requirements.
  10. Conducting Open Book Procurements (both pricing and contracting) builds a supplier’s internal commercial capability and drives commercial contract management and financial management principles.

Benefits of Open Book Pricing / Contracting for Customers

  1. Open Book Pricing allows for greater cost and price transparency, which underpins Value for Money assurance and provides the necessary detail to conduct commercial due diligence.
  2. Open Book Contracting is capable of delivering value for money initially at Contract Award and through collaborative working and levers for innovation it can deliver TCO reduction.
  3. Allows for relationship development with the Supplier (and partners) which is beneficial for ensuring a stable baseline in developed which enables effective commercial contract management.
  4. Open Book Contracting allows for payment and commercial incentives to be linked to Key Performance Indicators (KPI) which can be directly linked to internal business requirements.

Further Considerations

  1. Open Book Pricing requires a partnered behavioural approach from both parties. If Open Book is used as a “weapon” by Customers’ then there is a risk that the process may break down or that customers may not extract the potential benefits this commercial model can facilitate.
  2. Open Book must be used to drive benefits, and therefore the customer must be mature in understanding its own requirements and success criteria.
  3. Open Book Contracting requires highly trained commercial contracts staff on all sides, who must have the necessary skillset and behaviours to operate in a transparent and structured manner.
  4. Suppliers must have accounting systems that are capable of accurately recording contract costs, and these should preferably be integrated with contract management and financial management systems / processes.
  5. Open Book Pricing can remove the advantages of Market Based Pricing methodologies deployed by Suppliers, although these can be mitigated by making exceptions through the procurement process (i.e. transparency can be applied against specific quants only such as labour days only, not rate).
  6. Open Book may be difficult for suppliers to sell internally, especially without the necessary expertise to communicate the potential benefits, including increased profitability and customer retention.

Conclusion

This blog post is a top-level summary of some of the benefits (and risks) that Open Book Pricing and Contracting can offer if deployed correctly. This should not be taken as an complete guide to the subject and should you or your organisation require specialist assistance, we would advise deployment of a specialist commercial contract manager to ensure success. Should you wish to engage with Athena Commercial regarding a future or current Open Book engagement, we would be more than happy to discuss particulars with you in more detail.

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Athena Commercial February 4, 2019 0 Comments
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