Why do we design complexity into contract management? We take a period contract and then split it into an initial contract period with a formal contract review and one (or maybe two) optional extension periods. Maybe we could consider awarding a contract for the full contract term and have no optional extension periods. Here’s why!
Factors to consider
The factors that affect the initial term and number and duration of optional extension periods in procurement contracts include:
1. The transaction costs for each party. Some complex projects cost the client hundreds of thousands of dollars to manage the tender process. And the bidders may spend thousands of dollars to respond. The initial contract period should be long enough to make that investment worthwhile for all parties.
2. The setup costs for each party. Whether you call it ‘set up’, ‘mobilisation’ or ‘transition in’, preparing for contracts – especially capital and infrastructure contracts- can cost the incoming contractor hundreds of thousands of dollars. The initial contract period should be long enough to recover that investment.
3. Market volatility can mean changes in factor costs, new regulations, exits or entrants to the market. Why would you let a five year contract if the market might be disrupted by a new entrant during year two?
4. The performance of the contractor. I once asked a procurement manager why her office supplies contract had a one year initial term followed by a two year optional extension. “Simple!”, she replied, “if the contractor is rubbish, we will kick them out at the end of the first year!”
5. Political or regulatory requirements. The availability of funds for the project -particularly in the third sector- may determine the duration of the initial term of the contract. And in political organisations, the term of contracts may align with electoral cycles.
The rationale is to strike a balance between the benefits of co-operation during the contract (better value for money) and the benefits of competition between contracts.
So what #1?
If these factors were considered by procurement teams, then there would be a wide variety in initial contract terms as well as a wide variety in the number and duration of optional extensions. But that is not true, is it? Instead, there are patterns like;
· three year initial term plus one year optional extension
· two years plus one year
· two years plus two years
I worked for one organisation where every contract for goods and services began at the start of the financial year, had a 12 month fixed price clause, and every contract had a 12 month duration. While that is an extreme example, it highlights that some organisations have ‘templates’ that that they apply to their contract portfolio. My contention is that the permutation of initial contract term and optional extension is a matter of habit, not logic. If we truly believed in aggregation, wouldn’t we let a four year contract?
The sad reality
Whatever the permutation of initial period and optional extensions, the sad reality is that most optional extensions become self-fulfilling prophecies. The client either doesn’t prepare in time to re-tender the contract at the end of the initial period, or they simply don’t have the internal bandwidth to manage the tender process. Whatever the reason, most optional extensions are granted. So why bother with the pretence of optional extensions? Why not just leverage the full contract term at the outset?
Termination for convenience
The mystery of why clients bother with the rigmarole of initial periods, contract reviews and optional extensions is further compounded by the preference of lawyers for including termination for convenience clauses. More and more lawyers seek to include a termination for convenience clause in standard contract templates, as the clause creates flexibility for the client. The conventional wisdom among lawyers is that the use of termination for convenience is not limited by considerations of good faith, (although there is still a duty to act honestly.) In other words, the card can be played when it suits the client.
There have been some recent high profile contract terminations (cough, the Commonwealth Games) and one reason why is that lawyers prefer the flexibility of a termination for convenience clause. This is because even if the supplier is in breach of their obligations, there is still a requirement on the client to prove the breach. How much easier just to terminate using the termination for convenience clause, because you can?
The point is this; if you can terminate the contract when it suits you, without having to assemble evidence or prove poor performance, why not just let the contract for the full contract term?
Turning Japanese
I used to teach how Japanese approaches to contracts (read: Toyota) differed from Western approaches. Apart from the obvious cultural differences, one example I used to teach is what happens if a buyer has a contract with a supplier at a price of $100, and a competitor to the contracted supplier approaches the buyer offering a price of $90? Most people suggested that Western buyers would either say “thank you very much!” and switch the business, or else invite the incumbent supplier to respond to an RFP also issued to their low-balling competitor. I would then point out that the preferred response of Japanese auto companies was to work with their existing supplier to get the price down to $90.
So what #2?
What does this say about the commitment of the parties to work together during the contract? I think most people would recognise that changing supplier just because there was another offer in the market suggests that the nature of the buyer’s commitment to their supplier was fragile. But hang on! Isn’t that exactly what Point 3 in my list of ‘factors to consider’ addressed? The point is that we value the opportunity to terminate for convenience when it suits us, and if the contractual model we have adopted allows us.
The price / volume relationship
Does the contract duration affect the price? My contention is that a contract duration which is less than the payback period on any client–specific investments will drive up the price. Suppliers will add a risk premium so that they do not lose money. But tenderers do not bank projected revenues. Commissions for salespeople are based on actual billings, not anticipated future billings. This means that a four-year contract may be preferable to a three-year contract with an optional one year extension. But anticipated future revenue remains numbers on a cash flow forecast, until, and if, they become numbers in the supplier’s bank account.
Now what?
If your standard suite of contract terms includes a termination for convenience clause, why bother with the additional complexity of formal contract reviews and potential optional extensions? If you have performance issues with the supplier you will probably invoke the termination for convenience clause in any case. You do not need to wait for the expiry of the initial contract term. Secondly, if the contractor’s competitiveness is poorer than their peers, then you will probably negotiate with them to try and improve their value proposition. If they remain uncompetitive, what are you most likely to do?
Exactly.