CONTRACT ACCOUNTING: Squeezing more profit out of in-flight accounts Reply

Most large accounts suffer from the same problem:  The variation between the crazy thing a business promised the customer and the ability to deliver it within profit margins.  In the multi-divisional organisation most departments and teams understand this.  Most senior executives understand the need to win bids versus the need to keep their jobs through sensible estimation and know it is a fine line to tread.

In many cases, the solution to this problem is often not better cost and schedule estimation.  In one global outsourcing company some accounts were run as loss-leaders (although this wasn’t the actual intention).  Had the business actually estimated the cost and schedule properly they would never have been able to deliver the solution with the requisite profit margin.  With this knowledge these projects would have been No-Bids.  Large companies need to build brand equity in various solution sectors (in this case, local government ICT outsourcing).  They can afford to break into the market at a loss and then create profitable new accounts through economies of scale.

There is another solution for larger, multi-divisional accounts.  The architecture of such agreements often aggregates risk premiums.  For instance, each team, unable to account precisely for the value of risk creates a risk ‘slush fund’ within their team’s section of the overall cost model.  In total, the final risk premium may be significant (and even price a business out of a bid).

The solution is a 4-step (4Rs) process:

  1. Re-Model.  First of all, the entire contract needs to be modelled as a single architecture.  Creating a single parametric model can be done in one of two ways.  Firstly, the firm can use the same quantitative factors (here we use financial data) across the model.  The firm may prefer to use quantitative factors multiplied by qualitative coefficients (e.g. the Defense sector).  In this case it is best to use existing models which are statistically correct, such as COSYSMO or COSYSMOR.
  2. Re-Package.  Risk needs to be re-packaged and sold to those who are most capable of dealing with it should it be realised.  This means creating an internal hedge market within the capability community to buys and sell risk.  There is a critical lesson to learn from the current crisis: (a) The financial markets are the most mature in their approach and maturity towards risk, but (b) risk needs to be dealt with operationally.  The lesson is clear.  Financial incentives provide the only means to truly motivate businesses to deal with risk but when it comes to actually performing those contingent actions there must be a realistic plan to do it.  Most risk plans are farcical and do not take into account office politics, organisational structures, technical difficulty, information for decision making and compressed time frames.  So, when selling risk ensure that the buyer has an adequate contingency plan to deal with the risk and is not just paying the highest price.
  3. Reduce.  Once these contingencies have been identified and the risks re-packaged the cost of the overall solution should be significantly lower.  If the risk contingencies are not significant then the main cost reduction should be in insurances to cover indemnities, warranties and general liabilities.
  4. Re-Negotiate.  Once the technical detail is calculated the hardest part is realising the gains.  In order to realise financial gains in an in-flight account the contract, or sections thereof, will most likely need to be renegotiated.  Lawyers are loathe to renegotiate contracts.  Despite the additional fee-earning capacity there are two institutional problems, namely:  (a) it may be seen as an admission of defeat that the initial contract is unsatisfactory, and (b) lawyers do not generally understand the financial maths behind the individual risks in the contract architecture.  However, the best way to renegotiate certain clauses is to (i) got through the sales/operational side of the customer’s business, and (ii) offer them money.  For instance, if the business stands to make 3% on its current margin then it could easily offer 0.25% to cover the legal fees of renegotiation or as a good faith payment.  It will, however, be critical to renegotiate the content with the operational/architectural teams as most lawyers only deal in absolutes (i.e. no liability or uncapped liability).

The difficulty with most accounts is seeing them holistically as an integrated architecture.  Most large deals are seen as separate pieces of a larger jigsaw puzzle.  Instead, it is advantageous to see the deal as a single system; all parts operating synergistically.  Modelling the system parametrically fulfils this goal.  Modelling it within financial parameters, in the manner shown above, empowers all departments and teams to work together to create high-performing accounts.

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