In the current economic environment, both Government and private sector organisations are actively seeking to reduce costs and implement savings measures. In light of this, it is becoming increasingly common for such organisations to review existing contracts, particularly long-term contracts, to identify steps which can be taken to reduce costs and identify potential savings.
Generally speaking, cost savings will be generated from improvements in efficiency (whether related to contract performance or contract management), changes to the risk allocation or a change to the scope of the contract. While there may be potential to generate significant cost savings, care needs to be taken to ensure that the provision of key services or the value for money proposition are not undermined and exposure to unnecessary risk is minimised.
In this article we'll look at some of the steps and considerations which organisations can take to identify and implement savings measures under existing contracts.
Efficient contract management
Any review of an existing contract should include an assessment of how the organisation is managing the contract to ensure that it is being done in the most effective and efficient manner. Are those responsible for the management of the contract appropriately qualified and do they understand how the contract works?
For example, payment- and performance-based contracting regimes can be complex and it is important to ensure that they are being implemented appropriately. We have seen instances where those responsible for monitoring contractor performance do not have a thorough understanding of how the performance-based contracting regime (including the KPIs) work and accordingly do not record all contract non-performances, resulting in an overpayment to the contractor.
Another example is where the contract price has been incorrectly indexed over many years, resulting in significant overpayments to the contractor. Are invoices being reviewed properly to ensure that the correct rates are being applied where the contract contains multiple rates (eg. labour rates and margins on materials)? Is the contract being managed in such a way that unjustifiable administrative burdens are imposed on the contractor?
Effective use of contract services
If the scope of services or capability being provided and paid for under a contract are not being adequately utilised, consideration will need to be given as to whether the contract should be amended to reduce the scope of services or how any underutilised capacity can be better used. For example, underutilised capacity could be made available to others to reduce costs and ensure a more efficient use of the service.
Cost savings provisions
Many contracts contain provisions requiring the contractor to endeavour to identify and implement cost saving measures. Contractors can be encouraged to identify such measures in performing the contract in order to reduce costs. Contractors will have a greater incentive to do so where they receive a share of any resulting net savings.
Risk should be allocated to the party best able to manage that risk. The contract price will typically include a premium for any risk allocated to the contractor. The risk allocation can be reviewed in order to ensure that it is appropriate and whether there is any risk which can be transferred to the organisation in return for a reduction in the contract price.
For example, to the extent that the contractor shares the risk for capital costs arising from a general change in law, that risk can be transferred to the organisation. We have seen instances where the caps on the contractor's liability under the contract or the "at risk amount" for performance-based contracting regimes have been reduced in return for a reduction in the contract price. Care needs to be taken to ensure that any reallocation of risk is appropriate and provides value for money.
Reducing the administrative burden
Contracts which are too complex or which impose unnecessary administrative burdens on the parties can be simplified to generate cost savings. Examples include contracts which have a large number of KPIs, many of which effectively measure the same thing or are not required to effectively monitor and incentivise contractor performance, or contracts which require the contractor to prepare and submit numerous project plans and regularly update them where it may not be necessary.
Release of performance security
Contractors often provide a performance security in the form of a bank undertaking in favour of the organisation to secure performance of its obligations under the contract, but the cost can be significant and is generally charged on a cost pass through basis. An early release or reduction in the amount secured by a performance security in return for a reduction in the contract price can be considered as long as it is done carefully, in light of an overall risk assessment for the contract, as it provides a key contractual protection in the event of contractor non-performance.
Reduction in standard or scope of services
The scope of services provided under the contract when it was signed may no longer reflect the requirements of the organisation. The contract may be amended to remove services which are no longer required or to reduce the volume of certain services. This may be in return for the inclusion of additional services or increasing the volume of other existing services.
Where appropriate, it is also possible to lower the standard to which services are provided by the contractor. What appear to be minor reductions in the quality of service can produce significant cost savings, because the cost, and risk to the contractor, in providing a "top of the curve" service level is disproportionately high.
Recurring services vs ad-hoc services
Some contracts characterise services as recurring services, which are provided for a fixed annual fee, or ad-hoc services, which are provided in accordance with a schedule of rates.
Often contracts require the contractor to provide the recurring services for the fixed fee, regardless of the volume of the services or subject to a cap on the rate of effort. Accordingly, the fixed annual fee will typically reflect the risk that the contractor is required to provide a level of services in excess of that anticipated or up to the cap on the rate of effort.
While some services clearly fall within one of the two categories, others will be difficult to characterise. Accordingly, it is very unusual for the recurring services/ad-hoc services mix to be exactly right, particularly as circumstances change over time.
Savings can be generated by reviewing the recurring services/ad-hoc services mix. For example, if there are any recurring services which are no longer required on a regular basis, or the cap on the rate of effort is no longer appropriate, you should consider either reducing the cap on the rate of effort or reclassifying the service as an ad-hoc service.
Contracts can be reviewed to ascertain whether the indices used for the escalation of the contract price are appropriate and continue to be representative of the contractor's costs. The choice of index can have a significant impact on the contract price. Indices which were appropriate when the contract was signed may no longer be appropriate due to the impact of certain sectors on the index since the contract was signed (eg. the mining sector).
Negotiating amendments to the contract
Contractors will generally require something in return for agreeing to changes to the contract which result in a reduction in the contract price or the scope of the services or result in an adverse change to the risk allocation under the contract. Incentives include an extension to the contract term or an agreement to exercise an existing option to extend the term and the inclusion of additional services within the scope of the contract. From a Government perspective, anything offered to the contractor will need to be considered in light of applicable procurement policy.
As outlined above, there are many steps which can be taken to identify and implement savings measures under existing contracts through a review of efficiency, scope and risk. Which steps are going to be the most effective will need to be considered in light of the terms of the contract, the requirements of the organisation, and a detailed analysis of what is happening on the ground and the systems, processes and risks associated with each contract. Contractor engagement will be valuable and often essential in identifying potential savings measures.
Any steps taken to reduce costs and implement savings measures will need to represent value for money. Care needs to be taken to ensure that any cost savings are considered in light of the overall impact on the organisation – particularly scope and risk.