How to maintain unenforceable contracts

Outsourcing key operational activities may make them cost less, but it will also make them more difficult to manage. Unfortunately, in innovation-intensive industries such as biopharmaceuticals or high-tech, tight legal agreements can be virtually impossible to create or enforce.

by Stanford Graduate School of Business
Last Updated: 23 Jul 2013

According to Erica Plambeck, associate professor of operations, information and technology at the Stanford Graduate School of Business, strong relationships are more important than legally binding contracts when companies outsource key functions. She says that the increasing complexity of the types of collaborative deals being forged between companies means that firms are relying on threats of loss of future business for their partners rather than the court system to enforce those deals.

She cites the example of Toshiba, which is continually making design changes throughout its development process. If its suppliers delayed investing in capacity for a new product until a legally enforceable procurement contract was drawn-up, Toshiba would miss out on the small windows of opportunity that the consumer electronics market allows for releasing state-of-the-art products.

In a one-off transaction, a supplier might deliberately build too little capacity, assuming that Toshiba would attempt to negotiate a low price for production once the investment in capacity was made. But if the relationship was ongoing, Toshiba could persuade its supplier to invest in the extra capacity - to the advantage of both parties - without a contract.

Plambeck has written a series of papers on so-called relational contracts - agreements enforced by the value of the ongoing relationship. She has four recommendations for managers seeking to establish such contracts with their suppliers. First, she says, "figure out the potential to generate profits through a collaborative relationship and the dynamic value of that relationship to each partner".

She cites the example of a major oil company that built an innovative production facility for renewable energy in China, even though that required sharing valuable intellectual property (IP) assets with a local partner. This went against conventional wisdom because the weak court system for protecting IP in China could enable the partner to take the IP and set up on its own.

But the company realised that the relational contract it had with its partner would render such a move foolhardy in the extreme -the partner would merely be stealing IP that would soon be out-of-date, and its broken relationship with the oil company would starve it of new technological developments.

Second, in order to motivate suppliers to invest in innovation or capacity, it's best to have a relatively small number of suppliers, promise them you will provide them with a certain amount of business, and persuade them that investing in capacity will fuel their own growth.

Wal-Mart, for example, is attempting to do this by developing more collaborative, long-term relationships with its most innovative suppliers in certain high-impact product categories.

Third, when undertaking joint production, it is vitally important to have a common IT system for measuring and monitoring the contributions of all parties to the production process. If the joint production process is not underpinned by a shared IT system, each firm can blame the other if something goes wrong. Specialised software that makes clear to all exactly what happens throughout the process means that responsibility for failures can be pinpointed quickly and accurately.

Finally, it is important to remember that the mutual trust necessary for relational contracts to work is not based solely on rapport or business ethics, but is primarily about profit maximisation. "It's about making promises that are in your best interests to keep," says Plambeck.

Source: Erica Plambeck

Stanford Graduate School of Business

Review by:

Nick Loney

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