Why service contracts are hard to manage
You don't have to be a statistician at the Bureau of Labor Statistics to know that our economy is continuing to shift from manufacturing to service-based. Today, business services — from IT support functions to facilities management to outsourced call centers — account for one-third to one-half of every purchasing dollar spent in most companies. In the United States alone companies spend over $1.5 trillion on these business services.
But what you might not know is that your company is probably leaving money on the table. In fact, according to the Aberdeen Group, "services purchases represent one of the largest — and largely untapped — opportunities for cost savings at most organizations." (Aberdeen, Services Procurement Solutions: Strategic Levers for Savings, September 2004.)
So why do they represent the largest opportunities for costs savings? And why are service contracts harder to manage compared to those of manufactured goods? It's easy to understand the difference between a product and a service at the surface. However, these differences require unique approaches to sourcing and contracting.
What best differentiates services from products is their intangible nature. Unlike a box of widgets, services performed by an accountant or a Web hosting provider don't result in the ownership of a tangible good. This intangible nature makes it difficult to determine exactly what has been purchased and clearly makes a service contract more problematic to define, manage and evaluate.
A second feature of services is that, unlike manufactured goods, services are produced as they are consumed. In other words, services result from the interaction between the customer and the service provider and are generally unique to the customer. This typically requires the coordination and timing of multiple inputs and interactions. As the level of complexity and collaboration increases, the level of a service's variability or uniqueness also increases.
The difficulty in managing service contracts and service delivery is further compounded by this infinite variability, which is proportional to the interaction between customer and service provider. Unlike the homogenous nature of most tangible goods, services are typically customized to match the specific needs of the customer in order to provide customer-unique solutions which maximize total value. This heterogeneity clearly compounds the challenges of both managing multiple service contracts as well as evaluating a service provider relative to other competitors.
For business services performed at the enterprise level, where the level of complexity and collaborative inputs are drastically higher, the answers to common questions are often clouded. Without the right relationship management tools in place, it's challenging to find the answers to such basic questions as:
- Have you selected the best service provider for your specific needs?
- Are you paying premium prices for your services?
- Are you receiving the service levels for which you are paying?
- Are your vendors and partners in compliance with the terms of your agreement?
So what does this all mean? Unlike the relatively straightforward world of products, procuring services is a significantly more complex proposition, often involving definition, negotiation, management and evaluation from multiple internal and external parties. In short, what you see is not always what you get in the intangible world of services.
Collaborating with Procurement to Maximize Value
Because of all of these features of services, it's essential to start out by clearly setting and managing expectations both internally as well as externally with suppliers, partners or customers. Clearly spelling out and agreeing to the terms and details of a service agreement facilitates collaboration for parties within and across an enterprise and provides the foundation for forging productive and profitable business relationships. And it serves as the basis for managing and evaluating the performance of the service provider.
Service-level agreements (SLAs) and statements of work (SOWs) are unique to service contracts and their detailed development is critical to realizing the full value of a procured service. With this level of complexity, Procurement's involvement in services contracting is critical. In addition, tight collaboration with business units to understand their specific needs is an absolute requirement to creating detailed, effective and measurable service agreements. By integrating purchasing best practices with the detailed needs of the business unit, more accurate and defined scope and agreement can be created. Excluding Procurement generally leads to negative consequences, such as escalating costs and poor relationship definition, plus all of the typical drawbacks of this "maverick-type" spend. (See Fig. 1.)
The business unit is the service expert, ultimately defining the need, specifying the required skills and understanding the proper metrics and milestones necessary for detailing the overall service. Procurement complements this knowledge with the sourcing, negotiation and supplier management proficiency necessary for complete services contract execution. By facilitating internal collaboration during scope and SLA development, companies can shorten sourcing cycle times, reduce revisioning, help ensure receipt of the proper service levels, and help to create a more valuable relationship with the service provider — leading to lower costs in service fees, renegotiations and internal processes.
Furthermore, communication between the buying company and service provider is critical to ensuring successful results. By collaboratively developing specifications, SOWs and SLAs, both the buyer and service provider can agree on the expected outcomes and remove any ambiguity from the agreement before it is executed.
Enhancing Contract Visibility and Control
Given all of these complexities, it's easy to see how the details can get lost in the shuffle without the right tools for managing service contracts at an enterprise-wide level. As a result, many businesses are turning toward contract management (CM) solutions to help control all costs associated with the procurement of both services and goods, as well as to drive optimal supplier performance and compliance. And if the CM system is flexible and cross-functional, your Procurement organization can ease the complexity of service contract execution, enable enterprise-wide visibility into service agreements and supplier performance, and proactively manage all service contract components to ensure that you actually get what you pay for.
Successful services procurement is highly dependent upon the language of the entire service agreement, in addition to the contract itself. SLAs provide the measurable aspects of performance, such as network availability, response time, or accuracy. SOWs outline the specific services to be performed, with descriptions, deliverables and responsibilities. Each component requires extreme detail to minimize subjective interpretation and eliminate ambiguity and potential disagreements, but to be successful you must have visibility into these details.
After the contract is signed, evaluation of the service requires visibility into and enforcement of the agreed-upon performance metrics, such as profit sharing or cost reductions. Specific metrics that reflect a service provider's performance, such as network up-time of 99.7 percent, are deep within the agreement, not in an enterprise resource planning (ERP) system. Additionally, service-level termination events and performance credit events are contract details that ERP systems haven't been designed to leverage.
A CM solution can be used to leverage this deep agreement data and integrate with ERP systems to provide a full view of services agreements and allow accurate, detailed supplier management to realize the value of service relationships.
- With milestone and commitment management, contract managers can manage specific milestones and obligations as part of the contractual agreement, such as event and task completion dates, variable pricing arrangements, quality requirements and supplier responsibilities.
- With automatic notifications, based on the intelligent understanding of business terms, the CM solution will automatically send notifications and escalations to enforce milestones, commitments, and deadlines, avoiding penalties or late fees, or ensuring rebates and performance credits.
- For the transactional aspects of service relationships, ERP integration with the CM application provides automated compliance tracking to ensure proper pricing and timing around specific deliverables and any associated discounts or penalties, and ensuring that deliverables are completed before payment is made.
- An effective CM solution simplifies service provider management with easy-to-create supplier scorecards, which leverage agreement information to create detailed, agreement-based performance reports. Furthermore, an enterprise-wide solution will enable business units to enter accomplishments, metrics and results directly into the scorecard, leveraging the subjective expertise of the business unit or end user.
Of course, creating contracts properly from the start fosters more effective contract management. To this end, a successful CM solution enables collaborative contract authoring between both internal and external participants, facilitating cross-functional rule- and role-based review, editing, version tracking and approval. Many businesses also report that their service providers appreciate an easy to use, online RFx process, fast contract negotiations, and a vendor portal to facilitate communications — which all make it easier to do business with your company.
Looking at the success of organizations employing contract management solutions, we can conclude that CM is capable of bringing discipline and control to govern service agreements — generating advantages in cost savings through effective supplier selection, improved spend visibility and contract compliance, and shortened procurement cycle times. And these capabilities come just in time for an evolving service economy. As more functions are outsourced and more complexity requires outside expertise, your spend on services is almost guaranteed to increase.
"Welcome to a world," exclaims Tom Peters in his most recent book, Re-Imagine!, "where 'value' (damn near all value) is based on intangibles." Put another way, welcome to the world of services. As our networked, service-based economy continues to increase in complexity and sophistication, effective contract performance management is quickly becoming a required enterprise competency for the high-performing, service-reliant businesses of tomorrow.
About the Author: Jason Rushin brings over 10 years of experience in sourcing and technology as Nextance's director of product marketing. Prior to Nextance, Jason was a consulting manager at Accenture, responsible for strategic sourcing teams at a major energy company with $1.6 billion in total spend. He has also developed supply chain opportunities for other large enterprises, sourcing nearly one-half billion dollars in spend. Further, Jason has managed multiple strategic sourcing and e-procurement initiatives as well as led a Transportation sourcing segment at FreeMarkets (now Ariba). At Siebel Systems, he launched new products in key industry sectors, while also leading a change management team to improve company sales performance. Jason earned his BS from University of Pittsburgh and his MBA from Carnegie Mellon University.