5 Tips for Better Contracts: How to Improve Contract Negotiation in the Procurement Process
Challenges to Contract Management in Procurement
As a procurement professional, you’re measured on how accurately your commercial contracts are carried out. But few procurement professionals actually have clarity or visibility into the contracts that they’ve committed a significant amount of money to.
How familiar are you with your largest vendors’ contracts? You might assume that they’re being properly executed, but when’s the last time you checked? Most companies who think their supplier contracts are airtight just haven’t reviewed them recently enough.
For procurement teams engaged in vendor contracts with values in the billions, it’s essential to make sure you’re paying the right amount for the services you agreed upon. However, those massive contracts have a lot of room for overcharges and miscalculations, stemming from sources like:
Price mismatch
Quantity mismatch
Insurance charges
Incorrect duty charges
Incorrect labor charges
And more.
Even though procurement teams might be aware of substantial losses due to vendor contract non-compliance, they don’t always pursue those lost funds. Even though it sounds like an easy win, they have more at stake than just their money. They’re afraid of damaging vendor relationships. They don’t want to cash in today only to lose one of their biggest partners tomorrow. And they want to avoid switching vendors only to end up paying even more.
When you’re taking the time and resources to conduct a contract compliance audit, the audit becomes basically obsolete when you don’t take action on your findings. On top of that, you’re still out of all of the money you know you’re owed.
So how can you make the most of your contract compliance audits and leverage the insights you find to enhance your future procurement contracts and vendor relationships? Knowing what makes a good contract vs. a bad one, and what to look out for in the negotiation process, can equip you to safeguard your contracts and protect your key partnerships in the long-run.
Find out how establishing a contract compliance audit program helps companies stay on top of their supplier agreements in our guide, “The Ultimate Guide to a Contract Compliance Audit Program” >
Risks of Poor Contract Management in Procurement
1. Financial leakage
It may be the most obvious risk of poor contract management, but for many organizations, it’s also the most impactful. By closely examining your contracts with a contract compliance audit, you’ll likely find many sources of financial leakage via overcharges, underpayments, or incorrect charges.
It’s rare that the category manager will cross-check their payments with the contract throughout the partnership - the document is likely just too extensive and they just take the risk and trust that the terms are being properly upheld.
The problem is that this is rarely the case - and that’s not anybody’s fault. It’s just the nature of procurement contracts. But murkiness between parties and what’s expected of the partnership can lead to a mutual misunderstanding and subsequent financial leakage.
Visibility is crucial when it comes to contracts, but it’s something few companies truly have. If you don’t know what you’re being charged for, how it’s being calculated, or whether you have any money on the table, how are you supposed to know what changes you need to make?
2. Damaged vendor relationships
Vendor relationships are a fragile thing. You have to balance the needs of your business with the needs of a healthy partnership - and they don’t always align.
Confronting your largest vendors with identified areas of contract non-compliance is a slippery slope. Whether you’ve failed to pay them or they’ve failed to reimburse you, delivering that news to them can be a tough conversation.
When you identify flaws in vendor contracts, how do you resolve them delicately? It’s important to consider how the action you take on your vendors’ noncompliance will impact your future partnership. And for many companies, that’s enough of a threat to avoid taking any action at all.
By managing contractual expectations and risks before the engagement begins, you can implement the right contract language and internal processes to prevent these tricky negotiations from harming your reputation with that supplier down the road. And if you can identify future errors sooner rather than later, your supplier will be much more understanding of the red flags you raise to them.
By negotiating stronger contracts on the front end, procurement teams can avoid the conflict, stress, and financial loss of contract non-compliance from suppliers. But how do they do that?
It starts with knowing what you’re looking for - what is a “good” procurement contract?
Components to a Strong Procurement Contract
It might sound complicated to discern a good contract from a bad one - and that’s because it is. Every contract between two parties has vast room for variation.
Regardless of the nuances in your vendor relationship and agreement, the one uniting force between all strong, sound contracts is clarity. When negotiating and developing your contracts, make sure you establish clarity in the following areas:
1. Procurement contract language
Contracts with large vendors are long and complex. With any legal document, especially a lengthy vendor contract, it’s easy for the involved parties to become misaligned.
Contract language can introduce errors on both ends of the spectrum. If it’s too complex, littered with jargon and industry terminology, you and your vendor might have completely different understandings of what it actually means. On the flip side, if the language is too simple, that leaves much of the contract open to interpretation – widening the wiggle room for your vendor to make undisclosed charges or deliver below your expectations.
Perhaps the greatest oversight of ERP overall is that most ERPs just aren’t designed to catch many of the errors that most commonly plague AP departments. Variations, duplicate payments, and other simple errors fly past their radar all the time. These errors can result in delayed processing, incorrect data recording, and potential financial discrepancies.
2. Scope of partnership
Everybody loves a surprise…except for procurement and finance teams. In the context of a contract, you always want your expectations to line up with reality.
The scope of your partnership includes what the vendor will deliver to you, how much of it they’ll deliver, how they’ll deliver it, and when you can expect it. It’s the heart of the agreement – but when contracts don’t specify these things, there’s no way you can know for certain what to expect from your supplier.
You and your vendor must be aligned on the expectations of what they’ll deliver to you, and it’s best to clarify this upfront. Otherwise, you’d be in for a sudden and rude awakening later on in the partnership.
3. Payment terms
A contract might state that you’re going to pay your supplier - but a key detail many contracts leave out is when you’ll pay them. Whether you’re paying within 30, 60, or 90 days, details like that are important to your supplier. They might be expecting payment a full month or two before they receive it from you.
Additionally, the contract should clarify how exactly the payment will be delivered – credit, debit, check, etc. The specific financial arrangement between you and your vendor can be tailored to your needs as partners, but establishing this upfront will avoid any confusion or harsh negotiations further down the road.
4. Calculation of charges
There are several pricing mechanisms you and your supplier might choose to adhere to in determining when and how they’ll be paid. When contracts fail to define the calculation of charges, it can dramatically impact the way your costs are determined. Different pricing mechanisms that can be used in a contract include:
With so many options to choose from, you can’t assume that you’re on the same page as your supplier.
Here’s an example: Maybe you assume that you’re paying for a time and management contract and your supplier assumes you’re engaged in a cost plus contract. Cost plus contracts often leave the client incurring higher fees because they’re determined upfront, and don’t account for changes made to the contract during the engagement. Time and management contracts, however, allow the client to make changes to the project and their needs at any time, and can prevent you from overpaying the supplier.
So imagine how disappointed and surprised you would feel when the supplier charged you on a cost plus structure – costing significantly more than you anticipated. But at that point, it would be too late to make any changes – if the contract has been finalized, you’d have no standing to dispute the charge to operate under the time and management structure. That’s why upfront clarity is everything in your contracts – especially those with your biggest, most consequential suppliers.
5. Contract compliance audit rights
Though they’re possibly the most important inclusion in a contract, many companies fail to include audit rights in their supplier agreements. These are especially critical for companies who engage in contract compliance audits. Without them, you can’t ensure that the vendor will comply with the audit or even retain the necessary paperwork to do so.
When contracts exclude audit rights, all related terms are interpreted in favor of the supplier. With audit rights in your favor, you have grounds to fine or punish your supplier for errors or for hindering your ability to identify those errors. So if you come to them for a future contract compliance audit and they don’t have any of the data you need to carry out that audit, you can still recoup some of the funds you may have lost in the partnership.
5 Tips to Negotiate Better Procurement Contracts
When you find errors or weaknesses in current procurement contracts, there might not be much you can do to change them at that moment. But what you CAN do is carry your learnings with you to improve ALL of your future contracts.
1. Learn from weaknesses in current procurement contract
When you want to negotiate better future contracts, it’s important to define what exactly “better” means. By assessing the weaknesses in your current contracts, you can identify specific areas of improvement for future contracts.
For example, your current contract might lack certain service level agreements (SLAs), allowing your vendor to under-deliver without contractual consequences. Where could the wording have been clearer or stronger, establishing those legal guardrails on the frontend? With that context, you know that going forward, you need to make sure that SLAs are rigidly defined, outlining specific expectations, timeframes, and consequences.
SLAs and other key performance indicators (KPIs) help companies measure the performance of their suppliers and identify where the partnership has opportunities for improvement. Without them, it’s hard to learn and optimize your contracts to protect your finances.
That’s just one example, and in a complex vendor contract, there may be countless areas for improvement in the verbiage. Some clauses such as audit rights, early termination, and others should be made mandatory in your contracts to protect your finances and your partnership should any confusion arise.
2. Assess where your internal processes could be improved
Outside of the mere structure of your contract, the internal processes you’ve established are highly influential to the success of your partnership. Manual processes are often a key source of friction with supplier contracts because they inhibit the visibility you have into the contract as well as your speed to take action.
Automation isn’t a perfect solution, but it can ease the lift of many error-prone processes. Automating the verification of invoices, purchase orders, and receipts with automated checks can identify areas of overcharges as they occur so you can easily diagnose and resolve them.
It’s also crucial to remove barriers to communication and collaboration between internal teams. One team might have insights that could illuminate errors with the contract execution (more on that later!). For example, the negotiator of a contract is rarely the same person that’s executing it - but they should both share the same understanding of the contract, line by line. Keeping an open dialogue between the two can help maintain that shared understanding, but few teams actually enable this consistent communication.
Strengthening your internal flow and processes can improve visibility across the organization and in your partnerships. Plus, identifying contractual noncompliance earlier doesn’t just save your finances from flying out the door – your suppliers will appreciate the quick resolution over a historical audit months or years after the fact.
3. Address supplier red flags
Sometimes, you can identify red flags with your suppliers before you’ve even completed a contract compliance audit. During the course of your partnership with a supplier, it might feel overwhelming to routinely check the contract to ensure it’s being executed properly.
Here are a few red flags to keep an eye out for that should set off alarm bells that something’s not right:
Your vendor is capitalizing on unintended profit: If your vendor isn’t contractually constrained, they can find holes in the document where they can charge you for undefined goods or services. Make sure your contract restricts miscellaneous charges so your vendor can’t charge you out-of-the-blue for undetermined expenses.
You’ve never had an issue with your vendor: If you’ve been working with the same supplier for 5, 10, even 20 years, and you’ve never identified an overcharge or other payment error, you’re probably just not looking closely enough. Many procurement professionals assume that their long-term vendors are low-risk because they’ve been working together so long, but that’s not even remotely the case. Assume your oldest vendors carry as much risk as your new ones – errors can be unearthed in all contracts, new and old.
There’s trouble in your AP department: When you calculate the payments that need to be made on an invoice, you may naturally assume they’re all correct. You have no reason to assume your vendor isn’t complying with your contract. But signals from your AP department can alert you to potential payment errors that are due to overcharges from your vendor. If your AP department is flooded with credits – or it’s gone completely silent – that’s a sign to check on your vendor and your contract.
You’re not accounting for market forces: You might be used to negotiating the same contract year after year, but the world you’re operating in has changed drastically all around you. Your contract should account for market forces like inflation, rising costs, supply chain disruption, or any material changes that have been made to your partnership.
4. Vendor relationship management: Prepare to share responsibility
Protecting supplier relationships is one of the most important aspects of a contract compliance audit. You don’t want to approach a contract negotiation aiming to come out “the winner” - without considering your supplier’s point of view, you’re bound to lose.
It’s less expensive to retain existing suppliers than it is to acquire new ones, and that goes both ways. Both you and your supplier benefit from nurturing these lasting relationships - so how can you negotiate stronger contract terms that position both parties favorably?
Contracts are almost always written in the supplier’s favor. It makes sense – in a volatile market, you want your suppliers to be happy with the terms you’re giving them. But that can lead to a lot of unnecessary loss. If any little thing goes wrong in your contract, even if it’s not your fault (or not completely your fault), unbalanced contract terms can lead you to pay exorbitant fines or shoulder the responsibility of the error on your own.
Shared responsibility is a massively important component of a commercial contract. Both parties should be equally responsible and equally deterred from contract non-compliance. This might feel uncomfortable because it puts more accountability on your supplier, but in the end, it empowers both teams to hold up their end of the bargain and leads to a much smoother professional relationship.
That said, you want to make sure that the contract is truly fair – not swayed more in your favor than the supplier’s. You want to take both parties’ interests into account and present your vendor with a contract that benefits you both equally. If it’s only written in your favor, why would they have any incentive to agree?
5. Use clear, concise contract terms
A major source of contention, confusion, and non-compliance in vendor contracts comes from the way they’re worded. Because contracts are typically written in the favor of the vendor, they’re also riddled with industry jargon and unclear terms.
While overly complex wording should be avoided, overly simple terminology introduces its own set of risks as well. Though a contract should be clear and concise, it also needs to be comprehensive and thoroughly defined.
For example, “cost” might sound like a term with an obvious definition – but because of that, it’s actually too vague. Is it the cost to the vendor? A cost to you? A third, external cost to one of the parties involved?
Many companies have trouble walking the line between “too detailed” and “not detailed enough”. A great approach to this conundrum is to include examples wherever possible so that there’s less up in the air when contract conflict arises. Setting a precedent right off the bat helps to more quickly resolve disputes later on in the engagement.
Finally, as inconsequential as it might seem, grammar can actually completely alter the meaning of a contract; make sure every comma is placed with intention so that your sentences mean what you intended them to mean.
The need for concise specificity applies to every section of the contract: from the scope, to the payment terms, to the calculation of charges, and so on. At the end of the day, no wording in a contract should be left up to interpretation.
Improve Your Procurement Contracts Through Smart Negotiation
Most of the time, procurement teams have to wait for a contract compliance audit to gain any kind of visibility into their supplier agreements. By the time they actually bring in an auditor to examine the documents and assess their payments, it’s usually too late for a lot of the funds to be recovered.
The success of your contracts can be determined on day one through the power of negotiation. By constructing a bulletproof contract with concise language, defined clauses, and sections addressing previous contract weaknesses, you can save yourself from overcharges before they even occur.
FlexTecs’ contract compliance audit program helps procurement professionals identify contractual weaknesses, prevent and recover financial leakage, and protect their sacred supplier relationships. Get in touch with our team to find out how you can patch up leaky contracts: https://flextecs.com/contact.