Monday, December 15, 2014

How to Manage Contract Risk in Procurement (Part 1)

An Overview

In a series of articles commencing this month, we look at the relevant issues facing procurement specialists when managing risk in procurement contracts and offer some guidance and assistance when doing so. We start this month with a general introduction and will, next month, deal with specific legal issues arising and how best to deal with them in order to minimise such risks.

The goal of every commercial organisation is to undertake work in order to maximize its profits and to grow its business strategically. Ideally, it wants to do so whilst minimising risk and potential financial and legal exposure.

An essential element in achieving this is to fully understand and appreciate the contracts which it enters into throughout its normal course of business.

Contracts are mutually binding agreements which usually provide cross-obligations between the parties. Taking procurement as an example, the seller will be obligated to provide the specified product or service whilst the buyer is obligated to pay for it. If either party commits a breach, then such a legally binding relationship will be subject to determination and remedy by the courts or, if the parties so choose, by way of arbitration.

Procurement contracts: the buyer/seller relationship

All business throughout the entire business supply chain will, at some point or other be both buyer and seller. As such, wherever and whatever the business does as part of its commercial activities, conflict will exist between the two roles: the buyer wants to extract the maximum entitlement at minimal cost and the seller wants to win the contract but with the maximum profit potential.

Accordingly, consideration is required to be given to whether price is the only determinable factor in the selection of a supplier. Whether it is or not will depend on the actual product or service being sourced. If it is a relatively low prices standard off the shelf type commodity with few potential buyer risks, then price is likely to be the main driver or motivator.

This, however, is not (or shouldn’t be) the only factor in procurement contracts. The consideration of risk is absolutely essential in procurement; hence the phrase in tender processes that “…the buyer is not required to accept the lowest bid.”

In many procurement cases, the item or service is usually sourced from an external supplier although that is not always necessarily the position, particularly given changes in technology and development of companies’ ability to consider producing the item or service itself. As such, many companies now undertake processes in which to identify and justify procurement from either outside of the organisation or whether it is cost-effective to do it from within; known as “Make or buy analysis”.

With the increasing development of infrastructure, technology and e- commerce ability of the Sultanate, such analysis is now becoming a commonplace tool used by many business and organisations in Oman. Most notably, decisions are taken by using such an analysis to produce part of the product internally whilst outsourcing certain aspects or parts of it outside which, inevitably, leads to complex contractual arrangements. The art of procurement is rapidly becoming a science, which is now required to attract serious-minded procurement professionals where price is no longer necessarily viewed as king. Such professionals are required to be contract risk management specialists who appreciate the use of, and understand, evaluation criteria methods and procedure, including consideration of technical performance, on-going maintenance costs and limitations, track records of suppliers on similar procurement contracts and qualifications and experience of staff undertaking the required provision of the services or product.

An analysis of the key risks and a consideration of alternatives available is a crucial step in the procurement process and one which will be required to cover:

  1. Technical proposals, including methodology to be adopted;
  2. Commercial proposals – terms and conditions;
  3. Risks; and
  4. Price.

In order to undertake such an analysis, procurement specialists employ weighting systems in order to quantify qualitative (subjective) data (which minimises any personal prejudice towards the supplier), screening by evaluation criteria and subsequent contract negotiation. Current standard tender processes employed in Oman follow such a structure and are now becoming best practice and very effective procedures in the procurement of products and services across the country.

In our next article we will focus on the legal issues and concerns of managing risk in procurement contracts through the use of exclusion and limitation clauses and the validity thereof under Oman law.