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The legal opinions in this article are the author’s own, not WorldCC’s, and this is not legal advice.

Have you ever seen a black swan? Would you want one in your supply chain? Not when you consider the black swan theory, 1 developed by Nassim Nicholas Taleb -- a metaphor describing a sudden, unprecedented event that typically rolls out extremely unwelcomed black swan consequences!  We’ve seen many black swans through history such as the rise of the internet, cyber attacks, World War I, 9/11 in the U.S., the global financial crisis and the sinking of the Titanic – to mention a few.

Black swans are getting bigger, meaner and more common with examples like Covid-19 and Brexit. Both have resulted in unexpected levels of disruption and upheaval for supply chains -- meaning contract management has never been more critical.

Flexible contracting techniques are being developed to help tackle the prevalence of black swan disruptions. So, obviously, when businesses can prepare and manage these black swans they become more resilient and better able to adapt to unanticipated situations. But that task will not be so easy if we overlook three things contract managers should first consider to erase black swans in the supply chain permanently.

1. Deal with demand fluctuations

History tells us that black swan events often generate a high fluctuation in volume of demand for products. This trend is reflected in the bar graphs. In fact, the supply chain resilience report published by WMG2 reveals that businesses responding to the Covid-19 pandemic experienced vast fluctuations in demand for products or services before and after the pandemic lockdown. Significant increases in demand occurred very quickly and allowed little time for businesses to adapt or change processes. When businesses experienced massive variances and decreases in demand, they were typically less sudden, but the decreases amplified as the pandemic continued.

1-Oct-27-2021-01-35-54-25-PM

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This volume volatility presents operational challenges requiring businesses to implement new processes to manage stock and inventory. And the same is frequently an issue in supply chain contracting, which means contracts need to be more agile than ever in dealing with and responding to those changes.

From a customer's perspective, this agility provides supply chain resilience, and, from a supplier's perspective, it ensures the business is not left exposed when requirements change. Therefore, both parties to a contract should want to include the right provisions in the contract. Examples include provisions for the following objectives:

  • Develop a forecasting mechanism with binding orders to provide transparency and certainty of encouraging collaboration to both party’s benefit.
  • Create or update your inventory management provisions to set aside minimum stock holdings to act as a financial buffer. Then decide how it can be managed so that it does not become slow moving or obsolete.
  • Set up a strong contract governance process to help identify and proactively manage volume fluctuations and use a collaborative strategy to achieve success.
  • Leverage volume flexibility with cap/collar tolerances to provide contractual mechanisms that enable volumes to flex within a certain parameter to enable both customer and supplier to plan accordingly.
  • Use multiple-supply models keeping in mind that exclusivity or sole sourcing can generate better pricing, but it also removes flexibility, so procurement teams are increasingly looking at multi-sourcing for an acceptable price.
  • Practice transparency and ensure constant access to real-time data: Technology can be used to increase supply chain transparency with access to data to identify issues early on.
2. Behavioral contracting

When faced with disruption it is often human nature to turn to others for help. Certainty Covid-19 accelerated collaboration between parties. Rather than attempting to enforce contract terms as an immediate first step organizations began seeking more collaborative commercial resolution of the issues they were facing.  

The WMG report looked at how businesses had used collaboartion as a mechanism to help deal with some of the challenges and risks associated with both Covid-19 and a hard Brexit. Overall, the need for collaboration to deal with unchartered eventualities is much greater than when businesses are operating in a steady state with little interruption and uncertainty. Therefore, as a general trend, increased collaboration, and a contractual framework to support successful co-operation will be important.  

As a result, many businesses moved away from the traditional arms-length relationship of customer and supplier, to a more collaborative arrangement where parties seek to work together cooperatively for mutual benefit.

So, it is no surprise that we have seen the use of collaborative contracts rising steadily. These contracts, often called behavioral agreements, focus on outcomes. They move away from the traditional linear supply chain models to provide something more balanced, cooperative, and streamlined.

Focusing on outcomes ensures all parties are incentivized to work together for successful results. We are moving away from typical penalty-driven contracts with liquidated damages and termination rights, to a more outcome-based partnership that drives better behaviors.

3. Using the VUCA model.

The VUCA model (volatility, uncertainty, complexity, and ambiguity) describes response to ongoing, unpredictable now labeled a “new normal” in certain business industries. VUCA, which is a method businesses can use to deal with disruption, is today a strategic management model that many businesses use to help them categorize ways to respond to events.  It has been around for many years but is coming back on trend as result of some of the recent black swans. The model is a great example for how businesses can break things down. It enables you to think about ways that you can categorize your situation and deal with preventing that inertia where the situation just seems too large to move forward with. 

The model has two axes imaging first, the predictability of an event and second, the respective knowledge of the situation surrounding it.

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Contract managers can categorize each event into one of the quadrants as follows and when disruption hits the supply chain, use the following approaches and techniques to ensure that mitigation is leveraged effectively.

  • Volatility - High Predictability/High Knowledge
    • An example would be price fluctuations resulting from raw material price changes which impacts on margins.
    • Build resources to prepare; or building slack into the system. The steps can be expensive so your business investment should match the perceived risk.
  • Uncertainty – Low Predictability/High Knowledge
    • An example would be a new technology impacting the market or business operations.
    • Invest in information; or changing structures to add more analysis resource. Your aim is to reduce the ongoing uncertainty. 
  • Complexity – High Predictability/Low Knowledge
    • An example would be expanding into new territories each of which has its own regulatory requirements.
    • Restructure your resourcing strategy; or building up or buying in additional expertise or specialties to increase resourcing designed to deal with the relevant complexity.
  • Ambiguity – Low Predictability/Low Knowledge
    • An example would be Covid-19 impact
    • Generate hypothesis to test both cause and effect; or by experimenting with pilots designed to deal with the situation. The aim is to learn fast and apply those lessons learnt.

Lessons learned from black swan events such as Covid-19 and Brexit will be critical for business resilience. As we live and work in a world where disruption is the new normal, robust contract management is required to help deal with those challenges on a day-to-day basis.

Businesses should review their contracting processes, build in checklists for appropriate provisions and challenge themselves to think about contracts as outcome-based tools rather than merely tools to mitigate risk and limit liabilities. If we change the way we think about contract negotiation and contract management, it will deliver not only a more resilient supply chain, but better working relationships with customers and suppliers.

Finally, World Commerce & Contracting members should also check out the recent research report, Post Award Summary Report - The Value Compliance Uncertainty Framework (VCU) (worldcc.com).

ABOUT THE AUTHOR

Clare Francis is a commercial law partner specializing in business-critical projects including supply chain contracting, contractual joint ventures, business outsourcings and wholesale contract portfolio reviews.

ABOUT PINSENT MASONS LLP

This purpose-led, professional services business with law at the core, publishes this statement as part of their professional outreach mission: “We have a strong sense of integrity and put clients, communities, people and the planet before profit. We know your industry inside out, we understand that the world is changing, and we stand beside you as you face those changes."

END NOTES

  1. Black Swan Theory, WikipediaSupply Chain Resilience: Three Practical Solutions report published by WMG University of Warwick with Pinsent Masons LLP, Tata Consumer Products and Argon & Co

Content reflects views and opinions of the author and do not necessarily reflect the views and opinions of World Commerce & Contracting.

Clare Francis, Partner, Pinsent Masons LLP


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