During the late 1910s and early 1920s, the Ford Motor Corporation constructed the world’s largest industrial complex along the banks of the Rouge River in Dearborn, Michigan.
Henry Ford’s vision of mass production included not only the first production lines, but also the centralisation of the entire production chain.
Iron ore and coal were shipped in by Great Lakes steamers and railroad, iron ore smelted to produce iron, and then processed into steel. Rolling mills, forges and assembly workshops converted the steel into springs, axles and car bodies, foundries poured molten steel to produce engine blocks and cylinder heads. A massive glass factory manufactured the windscreens. The most basic of raw materials in, cars out. There was no place for suppliers or contracts – Ford basically owned the whole lot.
Fast forward to the 21st Century. A contract for a new tram system for a major Australian city has been awarded to a French company. The level 2 engineering will be carried out by a subcontractor in France, and the level 3 engineering by a contractor in Mexico; production will be contracted to 4 different companies in Europe, and UK developed software will be customised by a Chinese company.
Companies can no longer do everything for themselves, or afford to do so, and almost, if not all, major companies depend on a wide range of suppliers for services and materials. As an example, consider Royal Dutch Shell: one of the six oil and gas ‘supermajors’ and the sixth largest company in the world in 2016 by revenue. In 2016, of the $234bn revenue, $163bn was spent on purchases (i.e. contracts). This dwarfed internal spending on production and manufacturing ($28bn) and R&D ($1bn). Put simply, Shell relies on the special skills and capacity of its contractors to carry out its work.
This is the norm. Take Rolls-Royce, for example. The company uses the services of over 60 suppliers of pre-assembled modules from Spain to Japan providing pre-built modules as components for the Trent series of jet engines, assembled in Derby, UK.
So what has changed in the last 100 years?
Ever more complex technology with multiple components, overall specialisation beyond the economic competence of any individual company, ever-increasing competition, a shrinking world, in terms of both suppliers and customers and competition, ever tighter timescales and margins. At the same time user requirements have not only become more complex, but also increasingly hard to define, especially within software or other business based systems.
Contracts and Contract Management
The popular belief is that contracts and contract management are of interest only to lawyers and the commercial department. After all, the lawyers need to ensure legal protection for the company, and commercial specialists must ensure that the contracting process complies with competition and/ or procurement law, right?
Not necessarily! This is a common misunderstanding of the fundamental importance of contract formation and management: when a company contracts out the provision of any goods or services the risk to them increases. Fundamentally risk increases because of the difficulty of communicating to the supplier exactly what it is that’s required by the customer: easy enough if the contract is for the digging of a hole, but much harder if the requirement is for, say, a new customer relationship management system.
The objective in the development of any contract is simple: a clear understanding on the part of both parties as to what each will do, and a fair and well understood balance of risk and opportunity. The objective of contract management is equally simple, that is, to ensure compliance with the contract.
It’s as simple as that, however the difficulties of achieving this are considerable. And what if contract formation and management are weak? Rework, escalating, uncertain costs and timescales, increased risk, even non-delivery of the product or a failure to address the basic business needs which the contracted work was intended to address. This is why the skills of contract management are so important to business managers, if project and business objectives are to be met in a competitive environment.
Contract Management and the Project Manager
So what does this mean for today’s project manager and business manager? The manager of today must know about procurement and contracts. In short, there is a new tool in the managers’ tool kits – contract management! Here are just some of the components of procurement and contract management that must be mastered.
Knowing the Legal Framework – It should be understood that contracts exist in a legal framework.
- It is not necessary for the manager to become a lawyer, nor even an expert in laws of his or her own country. That said, he or she does need to have an awareness of the legal concepts in order to be able to effectively use the resources of the company legal specialists to put the details into place.
- In short, the manager needs to know the universally applied fundamentals of contract and procurement management that apply the world over and when (and how) to get the legal department involved. If a contract is set up and run correctly, there will be minimal need to get the lawyers involved. But if something doesn’t go right – get the lawyers to help navigate the legal mine field.
Defining Requirements – Have a systematic method of defining contract functional or technical requirements
- Defining and communicating the tangible requirements may be difficult, but so much more difficult is ensuring that the supplier understands the customer needs and expectations, including those that might be unstated or assumed, that sit behind the requirements.
- Major risks exist where requirements are ambiguous or missing. It is a very naïve approach to assume that as the supplier is a specialist in this area, that they understand what it is that is required.
Establishing Clear Roles and Responsibilities – know who is supposed to do what
- It must be remembered that the supplier’s horizon is the end of their delivery; this is usually different from the customer’s product delivery. These two differing viewpoints may colour how each sees contract delivery.
- The Contracting parties must be understood. In a world of joint ventures, partnerships, contractors and sub-contractors it may not be clear exactly with whom you have a contract.
- Have responsibilities been properly contracted down the chain? This is an example of an issue that normally only comes to the fore when something goes wrong and liabilities have been incurred. For example, you may have imposed strict safety requirements on your contractor. How can you be sure that they have imposed similar terms on their sub-contractor?
Managing Relationships – building long-term relationships
- Contracting relationships are only successful where there is an equitable balance of risk and opportunity. This may be achieved partly by assigning liability within the contract, but is more commonly achieved by the choice of pricing mechanism (for example lump-sum, cost re-imbursement or a variation). The wrong type of mechanism motivates the wrong type of performance. This factor was held as a major factor in the escalation in the cost of the Scottish Parliament Building to £414 million from the £109 million original estimate.
- Going through the effort of building a contract forces both parties to evaluate what is expected of each other in the relationship and how ‘things will work’. Expending the effort to do the hard work early establishes the foundation (and documents what needs to happen) so that if things go awry, you know what to do and how to resolve the issues. As one colleague has said many times – ‘Get the hard conversations done early and written down – the rest of the relationship will follow’.
Managing Risk – Contracts can be used to transfer risk to a third-party – but not all of it
- The normal extent of a supplier’s liability is rework in the event of failure, however the customer may have suffered severe consequential loss through a contractor’s failure.
- In 2016 a contractor arrived at a remote gas field in western Kazakhstan to repair a faulty compressor (important pieces of equipment used for maintaining or increasing gas flow). The contractor forgot to bring an essential tool, and because it was essential for the customer to have the compressor operating, the customer chartered a helicopter to bring the tool to site and allow the contractor to effect a repair. Who paid for the helicopter? The customer. This may seem unfair, however most contracts limit the supplier’s liability to the work being done, and not consequential cost outside of this. Damages usually extend to re-work, and the customer may even have to pay for work that the contractor has done. Certainly, a contract could be drawn allocating higher liability, but in that case the price would be higher. So, the risk remains with the customer.
Contracting Strategy – ensuring the optimum approach to project contract development and structure
- Complex projects involve multiple contracts, with complex interfaces. There are many ways of structuring the ‘contract map’, and getting contracts in place, with each option offering different balances of performance. The project manager must ensure that the final contracting strategy decided upon aligns with the Key Performance requirements of the project. By doing this, not only is the probability of the project achieving its business goals increased, but the risks surrounding this (both threats and opportunities) properly understood and managed.
- It is not for nothing that companies such as Rolls Royce and Shell talk about ‘Strategic Sourcing’. Strategic sourcing embraces all purchases made by a company, across projects, programs, operations and portfolios, the objective being to create partnerships with suppliers, to leverage value (for example through preferred supplier partnerships), and to optimise risk (for example in ensuring reliable supply). Given the massive importance of such supply chains, it is easy to see that strategic sourcing policies play a great part in embodying the organisation’s strategic intent.
- What significance does this have at project level? Simply this – the way in which organisations form contractual partnerships with their suppliers is one expression of their strategic intent. Successful organisations ensure that all their projects, programs and operations are aligned in this respect as much as any other. By this means organisational strategic objectives become one step closer.
Increasing complexity of business means that today’s project managers are frequently called upon to manage suppliers, whether these are to build a jet engine for us, or simply supply our stationery needs. Skills in this area perhaps form a special category, in that contracts are governed by national law, however it would be a mistake to believe that successful contracts can be left to the lawyers.
The skilled project manager understands that successful contracting involves all the considerations discussed above. Above all, they understand that contracts are formed with and managed by people, and interpersonal skills are critical in developing successful contracting relationships.