Imagine yourself reaching beyond today’s crisis management by telescoping into tomorrow. Based on your initial findings, you start by developing smarter forecasting techniques and new strategies for identifying the risk. Then, having reached that level, you start to realize that some contracts really are more equal than others!
How so? Why focus on them? And can you do that?
George Orwell’s 1945 book Animal Farm1 reflects the mantra - all animals are equal. After rebelling against their human masters, the farm animals begin living under this mantra by repeating it every day. But, as time passes, it becomes progressively more obvious that some animals are becoming the new masters. Eventually, the animals wake up to find the mantra has been changed to read, “all animals are equal - but some animals are more equal than others.”
Lesson for contract managers? Revolution never works. It just results in the masters changing! Businesses too often treat contracts as if all are the same, but in reality, some are more equal than others Specifically, we mean that the high materiality contracts should get the best of our management skills!
This article is based on information from Procurement Central, UK.2 It examines materiality and best practices for understanding supply arrangements and knowing how to align critical goods and services precisely with the strategic objectives of an organization.
The key is the overarching concept of materiality,3 a term that, when fully understood, will help us evaluate the contract by its direct relationship to commercial and legal issues that are important to our organization and learn how it then aligns with the market realities that affect our business success.
For starters, buyers and suppliers alike have been asking four questions in light of trying to survive our present turbulent times:
- How can we avoid contractual failure?
- Who is accountable for failure and with whom or where does responsibility lie?
- How do we avoid contractual disputes?
- How do we find resolutions to our challenges?
Answers will point to how well we manage a crisis like COVID-19 and how accurately we can forecast risks.
Understanding contract materiality
Before we can assess materiality, we need to decide what is important to our business and precisely how.
First of all, we should not approach any procurement task until we have answered one key question: if our proposed contract goes wrong, precisely how damaging will it be to our business and in what ways? The question reaches beyond the traditional idea of risk management or legal implications by focusing on relevant dynamics of risk to ensure we understand its potential impacts. This enables us to prepare an action plan to mitigate and manage anything that could happen -- including ‘worst case’ scenarios.
In the UK, the Prudential Regulation Authority (PRA),4 which regulates the financial services sector is refocusing the industry’s attention on operational resilience through outsourcing and third-party risk management.
I believe this is the right move. In fact the UK financial services industry has set the ‘gold standard’ in assessing and proactively managing third-party risk over the past ten years. They did this partly in response to Sarbanes Oxley5 and partly because of the growing issues of data protection which led to the trend-setting General Data Protection Regulation (GDPR).6 At least in theory, the UK financial services industry has a better grip on these risks than any other sector, considering the PRA Handbook (aka PRA Rulebook)7 has long demanded in-depth understanding, reporting and action on third-party risk. Third parties, of course, are not just suppliers.
COVID-19 has adversely impacted some organizations, and as a result, questions are being raised about quality, reliability, and timelines of suppliers’ service arrangements. Here the focus has been on personal protective equipment (PPE) and the international scramble to secure supplies. Similarly, food supplies have been impacted, resulting in the need to rationalize product lines to guarantee food availability in sufficient quantity.
At this point we are ready to revisit the question: are all contracts equal – or are some “more equal” than others? The operative word is materiality. All contracts need to be managed, but the amount of effort we assign to the administration task will be determined by the materiality of the transaction to our organization.
So, what is materiality?
By ‘materiality’ we mean how significant is the arrangement and what direct impact might non-performance or legal dispute have on our organization?
So, the idea of materiality helps us recognize the importance of a particular contract measured by direct reference to the issues that are important to our organization. Materiality uses language that is meaningful to our people and readily recognized and understood by them. This can be systemized by undertaking a standardized materiality assessment we at Procurement Central call a Contract Materiality Review (CMR).
The real point?
- Surely people know what is important – almost intuitively?
- And surely contract value (sales value or purchase value) is a good proxy for a proposed contract’s importance?
In reply to both questions we argue that value alone does not tell you anything about market conditions, the state of the marketplace, or the difficulties of amending (or escaping from) a contract if things go badly wrong. A CMR helps remedy these shortcomings and gives a consistent view that is meaningful to us. It enables management to better understand and determine where or when it becomes relevant to report risk exposure.
Can we assess materiality?
Materiality is not just a question of the financial size of the arrangement i.e. big contracts. Smaller third-party arrangements may be able to adversely impact our organization in its market, especially in terms of reputational damage and loss of confidence. Both are of concern to our own directors, but potentially also to local regulatory agencies. For example in the UK, the PRA shows great interest in its regulated sector (banks, insurance firms and other financial services companies). The PRA will demand these firms have a good appreciation of contracts with third parties (selling or buying) especially where such contracts might seriously impact or inconvenience the general public.
Some firms use an Excel tool – the Contract Materiality Review (CMR) -- to assess any third-party contractual relationship against dimensions of risk considered important to their business environment. The review will typically characterize a proposed contract as either Exceptional, High, Medium or Low materiality.
There are typically five dimensions of risk for measuring materiality:
- contract value,
- legal risk,
- reputation risk,
- market concentration risk, and
- business risk of change.
The schematic above reflects this idea. CMR enables our organization to characterize an existing or proposed, third-party contractual arrangement in terms of its potential materiality, and so adopt appropriate strategies to proactively work with internal managers (i.e. stakeholder engagement skills) and select the right commercial tools to set up the contract:
CMR enables risks to be recognized, visualized, measured and registered and then managed or reviewed on an ongoing basis, as well as mitigated in practice. Different organizations may, of course, develop different criteria, but we suggest the five above are relevant in most situations.
CMR, then, using pre-defined questions, provides a consistent and systematic review of the likely impact to our organization of a proposed new contract,. It is best practice for completed “materiality assessments” to be approved by the relevant business unit director.
Where CMRs are routinely used, and where the company has a risk department, it will periodically audit CMRs. A materiality assessment that registers a ‘High’ or ‘Exceptional’ rating would typically be flagged and sent to the risk department (or the relevant executive director) when the project starts – that is, long before anyone has signed a contract!
At Procurement Central we focus on helping clients better manage risk and keep their cost down. In our training sessions and advisory, we also encourage companies to:
- adopt a true category management approach to procurement to leverage our buying power;
- proactively engage with key stakeholders to achieve real buy-in;
- use Kraljic supplier8 positioning techniques to drive the conversation on risk versus profitability;
- use STEEPLE analysis9 to better appreciate the market in a holistic way; and
- proactively get the legalities lined-up before someone says, “initiate the contract this afternoon.”
Weathering the COVID-19 storm and beyond
Companies that effectively manage third party relationships (up and down the value chain) are weathering the present storm. Some, indeed, will benefit long term. Even before Covid, pressures mounted toward reshoring supplies because of perceived growing political risk (that’s the ‘P’ part of STEEPLE).
In addition, Chinese expansion, international trade dispute and Eurasia tensions all point towards greater supply uncertainty going forward. Questions surrounding quality of some off-shored operations have become more acute. Finally, heightened awareness of labor abuses (consider the Modern Slavery Act)10 must today be taken into account.
As a result, more firms are actively looking to either reshore (transfer a business operation that was sent overseas back to its original country) or at least, near-shore (transfer the operation to a nearby country). The realization that much of the Western world’s basic pharmaceutical supply (e.g. paracetamol) comes from India and potentially cannot be obtained when needed provides us another option to establish a local, scalable supply -- should that supply be required.
Reshoring requires project management skills, of course. Beyond that, making a strategic assessment of both supply and selling markets and using a thorough category management approach to supply, are basic building blocks.
And finally, what is your organization’s risk appetite? Is it defined? How does that appetite play out in terms of your day-to-day approach to contracts?
At Procurement Central we sometimes say that procurement is a bit like home decorating! Success and seamless collaboration basically comes down to thorough forethought and planning. The amount of effort we invest in preparing will impact overall project success. Preparation inevitably includes relevant staff awareness and training, hard and soft skills, and internal business alignment.
Digital procurement enabling
Much of what we have looked at so far is good, basic strategic procurement. An emerging factor is digital procurement. Some digital technologies are reasonably well embedded into procurement tasks like these:
- spend analytics,
- eInvoicing, and
And on the agenda for the next 5 years you will discover the following technology capabilities many of us will need:
- cognitive computing,
- artificial intelligence (AI)
- data visualization,
- collaboration networks,
- crowd sourcing, and
How we apply these technologies to our commercial strategies will become a key competitive differentiator. There will be winners and losers to be sure. To get the best value from emerging technologies, we must apply them as much to our material relationships, as to our high volume but low risk-value (transactional) tasks. The supermarket sector may set new trends in this arena.
One way or another, we need to get beyond today’s crisis management and into better forecasting and risk characterization. Remember, some contracts really are “more equal than others”! Let’s focus on them!
- Animal Farm by George Orwell - 1945 (Wikipedia)
- Procurement Central website
- Materiality definition
- Prudential Regulation Authority, UK
- Sarbanes-Oxley Act
- GDPR definition and content, Intersoft Consulting. See also Wikipedia explanation
- See explanation of the PRA Handbook (also referred to as PRA Rulebook)
- Kraljic supplier positioning techniques, definition
- STEEPLE analysis, definition
- Modern Slavery Act 2015
ABOUT THE AUTHOR
Peter Sammons is a Lead Trainer with Procurement Central. His book Contract Management – Core Business Competence is available from Kogan Page Publishing with further insights on the Contract Materiality Review tool (CMR). His forthcoming book title Right First Time – Buying & Integrating Advanced Technology will be available in the first quarter of 2021 from IT Governance Publishing.