Tim Cummins: The challenge of uncertainty

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Tim Cummins

Another of the major themes from the IACCM Americas conference was the challenge of uncertainty.

Many presentations touched on this topic and the demands it is placing on contracts and legal practitioners. In my opening presentation, I suggested that ‘the management of uncertainty’ is a key role for the contracting process, demanding a new and more flexible approach to contract terms and structures. This is reflected in the growing emphasis that negotiators place on change management, communications and other post-award governance principles. It also helps account for the lack of clarity over scope and goals (because these also become uncertain).

Dalip Raheja, CEO of the MPower Group, focused on the impact uncertainty has on skill requirements. For communities accustomed to dealing with relatively precise requirements and standards, the need for increased flexibility and more agile responses to rapidly changing conditions are challenging. They require much greater focus on collecting and analyzing business and market information. Dalip suggested that traditional strategic sourcing ‘is dead’, because organizations must discover more sustainable ways of achieving value. This will be through more balanced selection criteria, resulting in greater collaboration between trading partners so that they can drive greater innovation, and also adjust more readily when faced by uncertainty.

Tim Minahan, head of Marketing at Ariba, presented the results of a joint IACCM / Ariba study on the current state of sales contracting. These also reflect the growing challenge of managing customer requirements. The growth of uncertainty has made it increasingly difficult to define and manage contract scope and the research confirmed that companies with contract management software are coping much better than those without. Cycle times, communication and cooperation are all beneficiaries of automation.

Dan Mahlebashian, Chief Contracting Officer at General Motors, reflected on the challenges that GM confronted over the last 2 years and explained how the approach to procurement and supplier management has changed. He discussed the importance of increased collaboration as a way to handle unpredictable markets and ensure innovation. Achieving collaboration has required GM to rethink its approach to contracting – and in particular, to ensure a greater connection between front-end negotiation and post-award contract and relationship management.

Overall, the message was that uncertainty and change appear to be here to stay. They have made contracting far more important, both to ensure a common baseline and to enable the management of change. Organizations therefore need to invest in the tools, processes and skills for contract management – and existing practitioners must adjust their approach and focus on learning new ways.

Transfer Pricing Alert
Supply & Demand Chain this week carries a useful article on transfer pricing, with a warning that Governments are becoming increasingly energized by investigations into tax avoidance.

At a time of recession and public expenditure cuts, it is no wonder that Governments will be looking at every opportunity to raise revenues. Higher taxes will also increase the inclination of international corporations to become creative in their tax minimization techniques. The benefits of effective tax planning are enormous and with so much activity now undertaken offshore, the chances to take advantage of low-tax regimes abound.

Transfer pricing is of course the price or charge that applies when goods or services are transferred between different parts of the same enterprise. Tax authorities fear that such transfers could be manipulated to avoid taxes and therefore generally insist on an ‘arm’s-length’ principle. "The arm’s-length standard requires that the amount charged by one related party to another for a given product or service must be the same as it would be if the parties were not related. An arm’s-length price is the price that independent companies would pay for the same good or service purchased under the same or comparable circumstances."

This apparently simple principle is in fact very complex, since many factors can be used in determining what is truly ‘the same’. In addition, many companies may embed royalties or other charges into the price, and of course those royalties tend to be payable to a low-tax jurisdiction (for example, most software companies register ownership of their software products in a tax-friendly offshore location).

For companies with multinational operations and clients, there are also interesting opportunities to decide where title to goods will pass, or (in an internet age) where services will be provided. The implications of who takes ownership, where and when, can have significant impact on the eventual price and profitability. That isn’t simply because of taxes on income; the effect of charges such as import or export duties or sales taxes such as VAT are also of major significance. For example, I recall one deal in which I was involved where, by providing goods on consignment to the customer and retaining title until the eventual point of installation, total cost was reduced by more than 30%.

Not all companies have close links between their contract and financial staff, so the commercial opportunities from price and tax optimization are sometimes missed. Equally, this disconnect may result in substantial exposures if the terms of inter-company trade are not fully understood, or if actions by a particular country organization could lead to unexpected tax liabilities.
Knowledge in this area has always been important for a rounded contracts or commercial professional. Today, as the risks increase and Governments become more vigilant, it is essential.

Truth In Bidding
IACCM research has revealed widespread concern about the integrity of the bidding and negotiation process. Contracts and Legal practitioners recognize that this is the phase when foundations are laid for future claims and disputes. A recent survey suggests that failure to properly describe, understand or respond to requirements accounts for 40% of failed or troubled contracts. Other data implies that the percentage may be as high as 65%.
This should come as no surprise. Firstly, as with all mating systems, competition creates an incentive for the parties to maximize their attractiveness. Even if that does not lead to outright misrepresentation, it certainly encourages exaggeration of positive attributes and minimization (or omission) of those that are less attractive and could be the source of higher prices or future problems.

In business, the situation is made worse by a tendency to limit interactions between the parties during the bidding phase and to indulge in a negotiation process that they have been trained to view as some sort of game. This results in buyers defining requirements behind closed doors and often divulging only part of the truth to their potential partners. The supplier similarly prepares a proposal behind closed doors and works out how to obscure weaknesses in their capabilities. Each side then excludes participants who might ask awkward questions or probe for the truth, or delays their involvement until it is too late for them to ‘derail’ the deal.

In theory, partners who have worked together over time should be in a better position to judge the truth, but even that is no guarantee of increased success. Changes in personnel and the constant drive for innovation are two factors that may undermine the integrity or validity of the selection process. It is also often derailed by fundamentally incompatible goals that distort the performance of the parties in the execution of their agreement. Prime among these is the issue of price, though the allocation of risk comes a close second.

Ultimately, price is not in fact the most important thing to a buyer. It is the outcome cost that really matters. By focusing on lowest price, they frequently drive up the cost and force dishonesty by the bidder, who can win only by compromising their performance capabilities, and who then spends the post-award phase attempting to recover margin through highly contentious change procedures.

For the buyer, their belief that the supplier will try to avoid or amend their obligations causes the imposition of onerous risk terms, which divert the negotiations from the terms that might assist in reducing risk probability. These weaknesses are compounded by an attitude that it is the supplier’s job to succeed. This causes the customer to ignore key governance and accountability principles, in particular a failure to share in responsibility and allocate the right resources or mutual review procedures to oversee successful delivery.

In summary, we face a syndrome where bidding and selection processes lack due diligence and open, honest interactions between customer and supplier. This leads to unrealistic requirements and commitments. These in turn lead to a risk-allocating contract that establishes an environment of fault and blame. And from there, the relationship governance process offers little opportunity to keep the deal on track. It may sound complex to fix, but it is not. The situation demands a better planned and more integrated approach, which can best be driven by the customer and will require executive leadership to implement.

* Read more articles by Tim Cummins