Self-enforcing agreements and sourcing projects gone wrong

We are very pleased to feature a guest post from Dr Chris Lonsdale, Reader and Head of the Procurement and Operations Management Group at Birmingham University. The Birmingham Procurement MBA is one of the longest established and best rated in our field.

There has been discussion recently on Spend Matters about ‘why so many major sourcing projects go wrong’. As contributions have mentioned, this is not a discussion that will deliver a single answer. However, my travels over the years have suggested to me that a major reason for failure is that organisations frequently enter medium or large-scale contracts without possessing ‘self-enforcement mechanisms’.

Dr Chris Lonsdale

The aim of organisations when they procure goods and services should be to develop a self-enforcing agreement. That is, an agreement between the two parties that will be delivered by the supplier without significant conflict, either in or out of court.

Part of the task of developing a self-enforcing agreement was summed up well by Peter, in his recent book written with Fiona Czerniawska: “A good contract defines responsibilities clearly, is easy to understand and is reasonable and balanced in the eyes of both parties. As such, it sets the scene for a relationship that may not require much contractual argument”.

Beyond this foundation, it is necessary for organisations to consider whether their hopes for a positive relationship outcome are underpinned by any self-enforcement mechanisms. Such mechanisms can be understood as contractual or non-contractual features of a relationship that assist in ensuring the delivery of an agreement by a supplier without conflict.

The most obvious self-enforcement mechanism is the (expressed or implied) threat of exiting a relationship and returning to the market, assuming that alternative sources of supply exist. However, in the case of many large-scale, or even medium-sized, sourcing projects, exiting a relationship is not straight-forward. Even if there are provisions in the contract allowing the two parties to exit under certain circumstances, in practical terms such a move may be time-consuming and expensive and not attractive unless the relationship has very seriously broken down.

In these circumstances, managers must look elsewhere for credible self-enforcement mechanisms. One option, of course, is trust. In a sourcing situation, organisations can anticipate that they will be significantly locked-in to a supplier once a contract commences and select a supplier that has a reputation for trustworthy behaviour. That is, a supplier that will not exploit lock-in, or other buyer vulnerabilities, for additional profit.

However, many organisations feel uncomfortable about relying too much upon trust. It may develop during a contract period, but this is not guaranteed and, indeed, not actually that likely in some business sectors. As a result, managers must, once again, look elsewhere.

A further option is to, again, focus on the selection of the supplier, but, this time, include in the selection criteria the extent to which a supplier values your business. A supplier that highly values your current and future business is more likely to deliver upon its promises than those that consider your organisation to be, at best, a routine customer. In a recent report, Future Purchasing and Vantage Partners referred to this as finding suppliers with which there exists ‘strategic interdependence’.

Managers can also try to develop mutual dependency / lock-in. In a major project, it may be possible for both parties to make non-transferable investments in the relationship and thus both have a stake in its success. The transaction cost economics literature calls such a move the making of ‘credible commitments’ and argues that the posting of financial payments by one party (should joint investments not be feasible) can play a similar role.

Another common, if often badly implemented, self-enforcement mechanism are financial incentives. Deductions, bonuses and gain-shares can be included in the contract as a way of encouraging suppliers to align their behaviour with the wishes of the buying organisation.

Organisations can also benefit from the desire of a supplier to maintain its reputation in the market place – reputation is a further self-enforcement mechanism. Reputation is by no means a perfect mechanism, and doesn’t seem to operate at all in some business sectors, but research suggests that it is often effective at encouraging suppliers to honour, or even go beyond, agreements.

There are many other self-enforcement mechanisms that could also be discussed, for example, dual sourcing and property rights allocation. The key point, however, is that managers entering into a major contract should be asking themselves a key question related to the above discussion about self-enforcement. That is, what is my reason for believing that the supplier or suppliers will deliver the agreement reached in the pre-contract negotiations?

Is it that I can use the threat of exit? Is it that I have chosen a supplier that can be trusted to honour its agreements? Is it that I have chosen a supplier that highly values my business? Is it that I have developed other mechanisms? Is it that I have developed a combination of mechanisms - some can and, indeed, should be used in combination (for example, too much strain should not be put upon contractual incentives)?

If this question cannot be answered satisfactorily then there is a high risk of the relationship becoming something of a struggle. All bets are likely to be off regarding risk transfer, collaboration and innovation will come at a premium and hold-ups may occur over variations - all leading to a poor outcome. And, in the public sector, of course, it will mean more bad headlines and the wrath of the PAC.

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