Contracts not worth the paper

 

For the first time in history, we are hearing companies or indeed entire industry sectors telling their customers to go elsewhere. They are in the predicament of having to choose between going broke now or trying to renegotiate often fixed price contracts to something workable. So what’s gone wrong? Contracts can smell very fishy at the best of times, so how do you handle purchasing contracts – like an Octopus or a Dart?

For most businesses, contracts are actually a useless bundle of paper that gets brought out when the relationship between the parties is stuffed anyway, and you’re looking for a way out. The only guaranteed winners are the lawyers.

Residential home builders, especially project home builders, have over the years transitioned to fixed price contracts. It was convenient to calculate the construction cost of a “standard” house, and market it with the help of banks as a known financial exposure for all parties. Where they’ve come unstuck is that by building up a forward order book, sometimes a year in advance, the final sell price is locked in. In the past, the progress payment structure, basically underwritten by the banks, meant that the builder could to a large extent fund the building cost from the incoming payments, requiring reasonably low working capital.

Now what’s happened is that there is both a shortage of trades people (reducing availability and increasing costs), as well as a shortage of materials. The material shortage not only delays the construction program, because the builders didn’t lock in the materials costs at the same time as they locked in the sell price, according to the “fixed price” contract they are having to wear the massive and largely unpredicted cost increases of at least 30%. As the margins in the original quotes were traditionally low single figures, the choices are:

1. Try to hold subcontractors and materials suppliers to old prices. Just like the builder, they can’t wear the cost increases or they too would be broke. Besides, there’s a backlog of other work that is still paying the “spot” rates, so old loyalties have largely dissipated.
2. Ask the home buyer for price variations, despite the fixed price promise, under threat of not finishing the construction. This sounds like a path of less resistance, but very rarely does the buyer actually have the money – they usually borrowed up close to the maximums of what the banks would lend them. Why would the banks suddenly increase their exposure, with prudent lending restrictions often not making it possible anyway? Should the builder go broke, the banks theory is that the State Government building insurance schemes will cover the shortfall, in Qld capped at a maximum of $200,000 (not to mention that the QBCC review time has already blown out from 2 weeks to 4 months to open new claims – with builders only just starting to fall over, this time frame will continue to blow out).
3. Cancel the job. Not great for the business reputation, but most likely the only option to live to fight another day.

Metricon, Stroud Homes and several large builders all the way down to the small builders are in the same predicament of finding themselves actually on the path of going broke in a building boom. In many cases, the end result is going to be the same: many new home “owners” waiting on unfinished homes.

Soaring input costs is decimating other industry segments. In a similar manner, the whole Tier 2 energy retailer market is busy telling their customers to go elsewhere. 412,284 customers or 19.2% of all energy users in Qld have chosen to lock in lower energy rates with these smaller retailers. Queensland already has the highest electricity prices in the country, and these retailers are caught with projected triple digit cost increases (that’s right, they are exposed to more than a doubling of the generation costs). The rising cost of coal (which supplies more than three quarters of Qld’s energy needs) is one reason for the increase, with future increases expected because of the push for increased use of renewable energy and supply chain issues (the impact of the Ukraine war on oil and gas for instance). The big three large energy retailers account for the remaining 80.8% of the Qld market and have the benefit of being both a generator and retailer and use their bigger bulk buying power to mitigate the worst increases whilst also being able to play the spot price market in what they charge the smaller Tier 2 retailers, thereby limiting their own cost increases.

In conclusion, all businesses should think about what they want to achieve with a contract. My philosophy is that the contract you insist on with your customer should be one that you would be happy to be applied in reverse, making it a fair contract. It should also be simple enough that both parties can work out what the contract entails, without any lawyers.

And finally, is the contract adding any value? Think about contracts in the context of whether your business is an Octopus or a Dart:

How many people does it take in your business to change a light bulb in the Managers office?

Many businesses are like an Octopus, with plenty of tentacles involved:

• A person finds a contractor to do the work.
• The purchasing department needs to get at least two competitive quotes for the light bulb from the list of approved suppliers.
• Another department needs to first check the supplier and contractor for compliance (work processes, insurances, questionnaires on slave labour and discrimination as well as the companies ethical and environmental policies etc).
• The legal department sends off the supply terms and conditions contract, and “negotiates” things like liquidated damages should the light bulb not be replaced within a certain time frame.
• The purchasing department then need to raise a purchase order from a purchase request signed off by all the relevant approving managers.
• The logistics department co-ordinates the freight.
• Once the light bulb arrives, the contractor can attend site. But not before having completed all the site inductions and gone through the Safe Work procedures.
• Assuming the supplier has agreed to give credit and not require payment up front, the accounts department needs to receive the compliant invoice before it can be scheduled in for payment at end of month plus 30 days.

Meanwhile, the Managers remains in the dark until all the tentacles have completed the processes. Could be weeks, could be months.

Or, like a Dart, does your business duck around the corner to a local business to buy the bulb, and reach up on a small step ladder to change the bulb with a suitable quantity of common sense?

Ask yourself: Do your purchasing processes actually add value and give a better outcome?

Word from the wise

Finally, some light hearted purchasing wisdoms:

Stocktake saying: The easiest way to find missing inventory is to place a new purchase order.

Job ad for Purchasing role: “For this purchasing role, we need someone responsible”

Applicant response: “I am the one you want. In my last procurement job, every time there was a problem, they said I was responsible for it.”

As always, onwards and upwards!

Fred Carlsson

General Manager