No matter what kind of business you’re in, your business relies on contracts.
They are the basis of almost all our relationships — from suppliers to customers, partners, contractors, and staff. It’s essential these business contracts are watertight but the fact is, many are not.
What Is Contract Value?
Contract value is essentially the monetary value of a contract. It can range anywhere from a few hundred to millions of dollars.
All of this depends on the work that is carried out or the products that are requested.
Contract value also depends on the size of the entity that issues the initial proposal. A bid from an SME can be expected to have a lower contract value than a bid issued by a large enterprise of over 300 employees, for example.
Industry type also influences contact values. A contract for the construction of a wind powerplant would be quite significant. While a contract for short-term legal advice, for example, would be substantially less.
What is Contract Leakage?
Businesses are losing hundreds of thousands of dollars through what is called contract leakage — the difference between the expected contract value and the real value created in production.
That difference can be enormous. According to the International Association for Contract & Commercial Management (IACCM), poor contract management costs companies up to 9% of their revenue. That’s a huge hit on the bottom line! But there’s a solution.
What are the Causes of Contract Leakage?
Leakage can happen both before the contract is signed (signing substandard contracts) and in execution (poor understanding of agreements and inability to execute the conditions).
Often, it is contract technicalities that create contract leakage. These are clauses governing how a product or service should be produced that was never cleared with the appropriate internal department, supplier, or contractor.
In some cases – for example, if a customer has a non-negotiable part specification for a factory that cannot produce it — the technicality is big enough to grind an entire project to a halt and jeopardize the contract and ultimately the business relationship.
These are some common examples of contract leakage, from the IACCM:
- Invoicing errors: If the correct contract terms or pricing don’t make it to the invoices sent, creating a difference in the value your company expected to bill and the actual billing price. This frequently happens when finance staff comes across unexpected terms or complicated contracts they don’t know how to bill for.
- Failure to engage stakeholders: A stakeholder is either an individual, group, or organization that is directly affected by the outcome of a contract. The fulfillment of the contract could depend, to a large extent, on how well the contractual relationships between these parties are managed. Poor contract management regarding stakeholder engagement can have devastating effects on a project.
- Unrealized pricing adjustments: This is the difference in the price of something now compared with some point in the past.
Generally, it impacts companies that buy components or products to improve or upsell them later. Having a handle on the actual value of your inventory means you will always know what a contract is worth at a certain time.
- Non-compliant work: If the work provided for in the contract was done in part or wholly outside the scope of the contract. A simple example is a construction contract that requires a redevelopment to be done according to a number of building codes. If the redevelopment is done in any other way, it would be considered non-compliant. In order to be compliant, your business must communicate the requirements of your contracts to the teams fulfilling them.
- Delivery failures: Contracts also stipulate how and when a product or service will be delivered, and failures to live up to expectations are a business relationship-killer.
Any of these contract leakage types can result in poor customer experiences, lost renewal opportunities, and lost business.
Is My Business Being Damaged by Contract Leakage?
Here are some warning signs that you might have contract leakage:
- Disagreement over contract scope: Given the complex nature of contracts, disputes are nothing out of the ordinary in contractual relationships. One area that is often the basis of dispute or claim is the lack of clarity over the scope of work issued in the contract.
- Weaknesses in contract change management: Change management is the process of renegotiating and implementing alterations in a contract. Ideally, these alterations are addressed as changes occur.
- Performance failures due to over-commitment: Oftentimes contractors will bind or obligate themselves beyond the ability of fulfillment. It’s important to be wary of over-commitment as you might be actively sabotaging the project by taking on too much work. Think realistically, and whether you can complete the obligation within the given timeframe, for example.
- Inappropriate contract structures: A surprising number of contracts are outdated, too long, structured in an old-fashioned way, and filled with jargon, ambiguities, undefined terms, lengthy paragraphs, and redundancies. These contracts lead to financial losses that could be easily bypassed with proper contract management.
- Disputes about pricing: Among the most common contract disputes are disputes over price changes. Ever since the COVID-19 crisis started in 2020, there has been a marked increase in the number of pricing disputes across almost all industries.
- Issues with subcontractors: Subcontracting could result in you losing control over the timeliness and quality of work. If certain requirements aren’t stipulated in your contract, it will lead to poor performance quality and value leakage.
- Limited use of contract technology: For organizations with numerous, multi-faceted contracts, working without a proper contract management system is a risky endeavor. It could lead to inefficiency and loss of quality in performance and analysis — ultimately damaging the project as a whole.
Contract value leakage has several negative effects, but the primary consequences are sacrificed financial benefits, unnecessary recurring costs, legal penalties, and lost upsell, cross-sell, and renewal opportunities.
In Practice: Poor Contract Management Jeopardized FDA Approval
A Fortune 500 company discovered its contract leakage was not only killing its business but also endangering its ability to sell to the multi-billion-dollar US market.
Procurement research company SpendEdge evaluated a food and beverage company and discovered their contract management processes made it impossible for the company to follow FDA and EPA regulations.
They found that the company:
- Had a lack of scope understanding and visibility, meaning it was hard to see and track what is going on, especially in aggregate.
- Could not easily generate important data. It was attempting to correlate email threads with spreadsheets to manage contract fulfillment.
- Was struggling to remain compliant with new rules from the FDA and EPA.
- Did not have business rules for contracts, which meant there were often contracting errors and time-consuming runarounds.
How to Prevent Contract Leakage:
The solution for the company mentioned above was the implementation of a contract lifecycle management platform, which streamlined its contracting processes, allowing for dynamic communications across teams, and increased its profitability while reducing spending on contract management overall.
Contract management software like Anapact supports the entire process — from request through to review and redlining, approval, execution, storage, renewal, and disposition. Here’s how it can help:
- Clause libraries allow staff to create contracts only from clauses that have been approved by the relevant teams, meaning potential issues with fulfillment or compliance will be flagged before the contract is signed.
- Managed workflows mean that teams are always working from a single source of truth, leading to fewer invoicing errors.
- Automatic reporting takes care of compliance, naturally.
- Integrations with other tools reduce the risk of unrealized price adjustments and delivery failures, by connecting the contract terms with individual fulfillment and compliance parameters.
Contract Lifecycle Management: The Solution to Contract Leakage
The IACCM says contract leakage can be solved by standardizing the contracting process. It recommends the use of quality, tailored agreement templates, tools for negotiation including click accepts and playbooks, and clear service-level agreements (SLAs) and remedies.
Top organizations also stated that using a CLM helped them gain a 35% reduction in contract value leakage compared to the average industry competitor.
How is contract leakage impacting your bottom line? With huge benefits to profitability and new regulations in the mix, there is no better time to invest in your contract lifecycle management process.
Anapact is a best-in-class CLM platform developed by expert contract managers. Its extensive contract lifecycle management features can be utilized across every industry and come packed with contract templates that’ll help you demystify the CLM process. Schedule a free demo today.