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In general, contracts for indirect spending in our sample tended to be written more effectively than those for direct spending, but no particular industry or spending category outperformed others consistently. This analysis revealed that the majority of procurement contracts fall well short on a range of basic contract elements related to performance. Over the past year, McKinsey’s Rapid Procurement Contract Insights (RPCI) service line has reviewed more than 100 contracts against a comprehensive assessment grid of more than 60 criteria. These actions can enable procurement organizations to build the capabilities and expertise to write contracts that deliver better performance.
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Next, executives should seek to implement strategies that support more effective engagement in the precontracting, contract writing, and implementation and management phases. As a first step, companies must recognize the common pitfalls to writing and executing contracts as well as the essential elements of effective contracts. In our experience, the key to optimizing the entire process is an approach called contracting for performance-a formal agreement with a supplier that sets specific rewards and penalties for achieving, or failing to achieve, performance levels that affect the bottom line. To determine specific contract areas where companies are falling short, McKinsey conducted research that examined every facet of contract development and execution and found that companies face challenges in three parts of the contracting process-precontracting, contract writing, and implementation and vendor management. All of these factors limit a company’s ability to get better performance from their suppliers and vendors. Last, procurement often takes a narrow view of business value in setting terms and conditions, meaning that significant enablers for future value creation from demand, operations, contract management, or supply chain are often not incorporated into the contracts. Without a point of reference for what good looks like, bringing contracts in line with industry standards is not possible. Since contracts establish the “rules of the game” for the supplier relationship, they are a critical factor in generating value, particularly for services. In addition, 80 percent of procurement functions are not fully aware of competitive terms and contract structure. Lack of procurement resources or ownership tends to shift contractor management to the users in the functions requiring the product or service who are usually not trained to do it effectively. Several factors contribute to this lack of oversight and contract management: large procurement functions execute and monitor tens of thousands of contracts annually, on average, so the sheer volume can be overwhelming. Global 500, Fortune, accessed January 5, 2018,. For Fortune’s 2016 Global 500 companies, this 9 percent would have equaled $2.5 trillion in value. By underinvesting in this way, companies are overlooking a significant source of value: suboptimal contract terms and conditions combined with a lack of effective contract management can cause an erosion of value in sourcing equal to 9 percent of annual revenues.
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“5 common references for procurement benchmarking,” Purchasing & Procurement Center, accessed January 5, 2018,. In fact, across industries, total procurement operating expenses are typically less than 1 percent of total spending. Despite this outsized share, the majority of organizations invest relatively limited resources in contract development and vendor management. Most industries have a large majority of their spending locked in contracts: companies in utilities, aerospace and defense, and food manufacturing can have 90 percent or more of their annual revenues represented in contracts with suppliers and vendors.