Contract risk and compliance for all economic seasons.

Over the past decade, many firms have stepped up their use of outsourcing, licensing, sales channel and other relationships to extend their enterprises. These relationships are especially beneficial during tough economic times as they help organizations cut costs, boost revenues and stay competitive.

But these arrangements also pose risks that financial executives must recognize and systematically address. The most obvious are the risks of contractual nonperformance or noncompliance. Other, more specific, risks include: financial viability of counterparties, deteriorating service levels in outsourcing arrangements, intellectual property violations, misreporting of revenue in sales channels as well as breaches of discount, rebate and warranty policies and procedures.

Given that risks are generally exacerbated during economic recessions, the downturn has prompted many firms to review programs for monitoring their extended enterprise.

Known as contract compliance, contract management or vendor management, these programs are often viewed as a "good enough" housekeeping function already in place. As many firms have discovered, however, reviewing and revamping these programs can generate significant returns. And lessons learned and discipline adopted during a downturn will typically stand a company in good stead when business conditions improve.

Overall management of contractual relationships can best be achieved in the context of a contract risk and compliance (CRC) program. CRC expands contract compliance and vendor management to address a broad range of issues and risks in business relationships. It also imposes greater discipline on contracting than a purely compliance-oriented program while improving collaboration between parties.

Indeed, a CRC program helps companies improve virtually every aspect of relationships, from defining goals, to screening vendors, to negotiating terms, to managing the relationship to reviewing results.

The current economic climate is a good time to review contract and vendor-management programs or to institutionalize gains realized from any recent ad-hoc improvements. In either case, a strong CRC program will enable organizations to derive the greatest benefit from business relationships.

Surveying the Landscape

A 2007 Deloitte survey found that a majority of contract risk and compliance programs suffer one or more of the following shortcomings: lack of clear ownership and standardized processes; contracts without proper audit clauses; failure to detect overcharges and revenue leaks; misperceptions--internally and externally--about the program; and orientation toward "policing" rather than collaborating.

Many survey respondents had overlooked opportunities to enhance the profitability of relationships or to shape vendors' behaviors and attitudes. Indeed, some companies could benefit from reshaping their attitudes. For instance, 61 percent of respondents expressed concern that CRC activities could damage relationships. Yet the same survey found that 70 percent of vendors actually expect contract-related inspections and audits, and litigation was the result of substantially less than 1 percent of contract audits.

Generally, a solid CRC program enhances, rather than damages, relationships. CRC clarifies goals and expectations; specifies service levels and monitoring devices; calls for appropriate disclosure and information sharing; and helps both organizations to perform as specified. It does not primarily aim to expose dishonest behavior, though it can. Instead, it aims to detect breaches that usually escape vendors' attention. Thus, CRC programs should be considered collaborative and constructive.

A CRC program extends the concept of vendor management to meet the needs of executives who oversee extended enterprises. In rethinking contract compliance programs, many financial executives find the following points useful:

* The program must address a broad range of risks that a contractual arrangement can create, not just the bargaining points and compliance concerns.

* A CRC program is designed, implemented and maintained to achieve specific goals, depending on the organization's needs, relationships and industry.

* The program should aim for transparency and mutual benefits. A good CRC program builds trust by increasing transparency and communication.

* Though CRC requires an investment, the related returns can be substantial, particularly when the program aims to enhance revenue or cut costs.

Guided by these precepts, firms interested in enhancing their current programs or establishing new ones should focus on design. Many vendor programs lack a cogent design because they grew willy-nilly as an organization expanded or because they reflect only a legalistic, compliance-focused orientation. Others spread themselves too thin in disjointed efforts to serve disparate business units.

Organizing Program Activities

A good CRC program starts before contracting begins, with analyses of likely costs and desired benefits and how to share them. The aim is a fair contract that motivates each party to perform as agreed.

Depending on the nature of the relationship and contract, the process moves on to define activity or service levels, sales volumes or warranty conditions and human resource, information technology or other considerations.

Quantifying these considerations and documenting outcomes is essential. But the focus should be on relevant, practical metrics and on reports that management will actually use. In this case, the oft-heard "too much data can be worse than too little" applies.

The contract itself must specify targets, metrics and access to one another's information. It must define the monitoring process and the right to "audit" information and activities, to conduct reviews and site visits, and to communicate with key individuals.

The resulting visibility into processes and clarification of boundaries will enhance the relationship and generate trust. It is no coincidence that "transparency" became such a watchword after the financial crisis. Given the consequences of its absence, it clearly makes sense to promote transparency in future relationships.

In that context, mechanisms for detecting and reporting changes in conditions, risks and objectives should be built into the contract and into the program. That implies the contract should specify the right to revise or renegotiate specific terms, and the conditions under which that right can be exercised.

The overarching rationale of a CRC program is to keep communications open and baseline information transparent, thereby helping to prevent mistakes, misunderstandings, disagreements and conflicts as well as to create mechanisms to resolve any that do arise.

Toward that end, external parties should be aware that a company has a CRC program. They should understand its general goals, features and requirements early in the contracting process. That way, expectations are either properly set at the outset or potential problem vendors can opt out before serious contracting begins.

DAVE ZECHNICH ([e-mail]) and CHRIS LEE ([e-mail]) are partners at Deloitte & Touche LLP.

EDITOR's NOTE: The full article--including six points of design and detailed features of a CRC program--can be found online at www.financialexecutives.org/mag_issue_2009_09.