Archive: October, 2016

The long and short of contract theory

My interest in the Nobel Prize for Economics was piqued when I heard that it had been awarded this year for work on contract theory. Like many procurement professionals, I’ve spent many long hours in meeting rooms with suppliers trying to get agreement on terms like liability, liquidated damages and payment. My training on contracts has been restricted to legal training and has ignored economics.

Since much of procurement strategy is driven by economics, what insights does contract theory provide?

Much of my research on contract theory has lead me to ask “so what?”. A “complete contract”, for example, “is one that describes the legal consequences of every possible scenario.” Clearly, this is impossible to achieve and therefore has little practical value. Academics say that they are not trying to provide definitive or unique answers but enable us to think clearly about the issues involved. This may be useful in a lecture hall but would be given short shrift by internal stakeholders and lawyers during a high pressured supplier negotiation.

Most contracts in the real world are incomplete and the Nobel laureates, Oliver Hart and Bengt Holmström, spent their time developing something called the principal agent theory. Hart’s work focuses on finding out whether services should be run by the public or private sector. Holmström’s work focused on the ways to motivate employees. Neither of these apply to supply agreements but some of the principles can be used to provide insights for procurement professionals.

Research, for example that summarised in Popular Science Background, provides two areas of contract theory that can be adapted to improve contract drafting and drive better performance. Firstly, understanding how performance can be rewarded in ways other than payment and secondly, developing a framework to drive overall contract performance.

Improve performance without paying for it

A key part of negotiating commercial contracts is defining who has the right to decide what to do when the parties cannot agree, for example, renewing the contract at the end of the contract duration. The party that has the right to decide has more bargaining power and therefore the opportunity to drive more value from the relationship. If the supplier, for example, has the right to extend the contract then they may invest more in the relationship, for example, by improving process efficiency or identifying ways to broadening the scope of work. In this way, allocating decision rights becomes an alternative to paying for performance. For those procurement professionals judged on savings, trading the right to decide for lower prices may deliver a better outcome.

Payment linked to information about actions

Paying suppliers for performance in high risk industries, such as the supply of commodities, runs the risk of rewarding them for good luck and punishing them for bad luck. There are two implications: firstly, it is better to reward suppliers for information about actions; secondly, payment structures should be developed in a way that takes the market into account.

A supplier who correctly anticipates an increase in cost, for example, due to an increase in the price of raw materials or an over-run by a contractor and who takes mitigating action should be better rewarded than one who unexpectantly benefits from the reduction in cost. This requires a more sophisticated contract and contract management process so may only apply to high value contracts.

To avoid rewarding or punishing suppliers based on luck, payment to suppliers in high risk industries should be more biased towards a fixed fee structure. Payments to suppliers in more stable environments should be more biased towards a performance measure.

“If you can’t measure it, you can’t improve it”

There are many adages about measurement and improvement such as the one above by Peter Drucker, the management guru. Contract theory, however, shows us that there is a risk if such adages are followed blindly.

Most supplier contracts consist of many different tasks, some of which may be difficult for the buyer to monitor. To deter suppliers from concentrating on tasks for which performance is easier to measure, it may be best to offer weak overall incentives. For example, if a supplier’s payment is dependent on (easy to measure) timely delivery then quality may slip.

Conclusion

I don’t think contract theory is going to change the way procurement professionals negotiate contracts but it provides us with some extra tools to help us get a better outcome.