London December 12, 2003 Contracts are of course a necessary component of any business relationships, but many top executives fail to realize the risks inherent in their companies' contracts, according to a report from solution provider Memba.
"Against all odds, most contracts languish in filing cabinets, even while the relationships that they underpin continue to function," wrote Memba in its report, "Top 10 Risks Inherent in Poor Contract Management." The solution provider added, "C level executives do not realize that these unmonitored contracts are time bombs in their organizations and that they raise many potential risks."
One of the top risks, according to the report, is when contracts lack critical documents or terms. This can occur, for example, when sales executives, under pressure to hit goals, add, remove or amend clauses in standard contracts to meet both buyers' and sellers' requirements. "Everyone knows that going through the legal department slows down the sales momentum to a point which may jeopardize a sale," Memba wrote. "The closer the sales target milestone, the higher the risk that a customized contract will not go through legal approval. Thus the risk of a contract lacking critical terms."
A further risk is that contracts or related documents will simply be lost. Memba cited a study by the International Association of Contract and Commercial Managers (IACCM) reporting that up to 10 percent of contracts are lost and that less than 20 percent of contracts reach their filing cabinets. This risk arises, for example, when original contracts have to move across multiple departments that may keep the original for its own archives and pass along a photocopy by mistake. Subsequently, the search to find the original may have to delve into archives in sales, purchasing, legal, finance, operations and support departments.
Companies may also be exposed to the risk of having annual contracts automatically roll over because notice to terminate the contract was not given in time. Memba reported that the average Fortune 1000 company, with between 20,000 and 40,000 contracts, loses millions every year because of rollovers and evergreens. The solution provider offers another example of the negative consequences of losing track of contract terms:
This manufacturer had received a purchase order for two pieces of equipment to be built according to the same specifications. The construction of the second equipment was conditional to the first one passing acceptance tests and was due to be delivered six months after the first one. The company had simply forgotten to build the second one. There was no reminder either in the [customer relationship management] or in the [enterprise resource planning] system, which were not designed to record conditional commitments.
Additional risks of poor contract management that Memba identified include:
- Customers Undercharged: This can occur, for example, when a contract for services expires but the company continues to provide the service to the customer.
- Vendors Overcharging: The solution provider cites the example of one company that reduced its license fees paid to a software firm by $200,000 by improving its contract management practices.
- Uncontrolled Impact of External Events: Occasionally, terms of a contract may have to be changed to account for new regulations, bankruptcy, legal settlements, mergers, acquisitions and so on. "In those circumstances, the ability to quickly retrieve all affected contracts is a real competitive advantage," Memba wrote.
- Time and Productivity Inefficiency: Many companies lose productivity because their staff must spend too much time searching for contracts among "islands of information." "In too many companies, retrieving the information and checking the status of a contract can take up to three days when it could take a single click with a proper IT system," Memba asserted.
- Employee Turnover Leading to Loss of Key Knowledge: Like it or not, companies often depend on information contained only in the heads of their contract managers. "Their initiatives have made them key personnel of the organization because access to the information is dependent upon their know-how," Memba wrote. "Let them leave, let their personal computer hard drive be wiped and you'll experience a dramatic loss of key knowledge."
- Compromised Customer Loyalty: A company's failure to properly meet its contractual obligations to its customers puts it at risk of losing those clients. "Managing contractual commitments is about keeping promises, whether it is a promise to deliver what has been ordered in the agreed time frame or a promise to pay within the agreed terms," Memba wrote.
- Competitive Disadvantage: "Contract management is about being in control," the solution provider asserts, suggesting that companies that have implemented contract management solutions can attain the control they need to meet their obligations and, in doing so, gain a competitive advantage over other companies that have not put in place such solutions.
For additional information on contract management best practices, see the SDCExec.com articles "Five Myths of Contract Management" (July 9, 2003), "Contract Management: Improving Corporate Governance" (July 21, 2003) and "Contract Management for Procurement Best Practices" (August 4, 2003).