Control Contract Costs with CLM

It’s said that every business should rest on four pillars: management, marketing, operations, and finance. Although each of those pillars is critical for a successful business, pillars need to stand on a strong foundation if they wish to truly support what they’re holding up. And for businesses, that foundation is made of contracts.

There are three main parts of the contracting process: 1) Precontract; 2) Contract writing; and 3) Managing implementation and vendors. But despite there being so few parts to the contracting process, a significant amount of money can get spent. It doesn’t help that contracts may range anywhere from straightforward agreements to highly complex, in-depth contracts.

This begs a question whose answer varies greatly: How much do contracts cost businesses, and how can technology (or more precisely legal tech) help control and reduce the amount of money spent on contracts?

Bigger is Better?

As a rule of thumb, the bigger and more complex the project, the higher the costs. But before you panic at the price tag, larger contracts present massive opportunities for greater revenue. Correspondingly, a good CLM will have a bigger impact on a contract’s overall cost. To be more precise, a good CLM can lead to greater savings and a larger return on the contract. 

People who are new or unfamiliar with contracts might wonder why. In short, when creating a contract, the costs can quickly add up. Some estimate that the average price of drafting a contract is over $800, while reviewing a contract is $500. A major reason for that is because lawyers may charge (on average) between $225 and $300 an hour. 

Those numbers may be on the low end of the spectrum. Others suggest that the average cost of reviewing a contract is upwards of $6,900.

The truth is probably somewhere in between, but the variable nature of contracts and their complexity means that it’s difficult to settle on one definitive number. There are many factors that need to be considered when calculating a contract’s cost: legal jurisdiction, domestic or international, industry, and more.

The financial impact of contractual failures is estimated at 9% of annual revenue, before considering the loss of reputation and legal damages.

To make matters more complicated, this doesn’t even take into account the impact of poor contract governance. The financial impact of contractual failures is estimated at 9% of annual revenue, before considering the loss of reputation and legal damages. For a $100 million company, that’s $9 million a year.

What does all this mean?

While it’s important to know the cost of a contract, it’s just as important to know how to control the cost. Regardless of how high or low the numbers are, one of the primary goals any business should have is to identify opportunities to optimize costs and unlock additional value. Not only to avoid wasting money on poor governance, but to find ways to realize cost savings, and by extension, more money for other endeavors.

Let’s dig a bit deeper into the specifics to shed light on why contracts cost what they do.

Direct vs Indirect Costs

As a quick refresher, contracts (and pretty much all business processes) experience both direct costs and indirect costs. 

Direct costs are expenses incurred for a specific objective. This typically includes supplies, materials, and labor. Sometimes, salaries and wages can be considered a direct cost, but only if the hired individual works exclusively on the object or for a set number of hours determined by contract. Simply put, all direct costs should be tied and traceable to a specific good or service. 

In the case of contracts, each contract has its own direct cost, which is a combination of the direct value plus any penalties and contract renewal options. Say we have a supply agreement worth $100,000 of goods and services, and no penalties or renewals occurred, then the total direct cost is $100,000. But imagine that we renewed the contract for an additional year with $1,000 in fees, but we did so late (incurring a $1,000 penalty in the process), then the direct cost would be $102,000.

Each contract has its own direct cost, which is a combination of the direct value plus any penalties and contract renewal options.

The quick and dirty definition of indirect costs is anything that can’t be considered a direct cost. This could be anything from the electricity and gas consumed by a building to the pencils, pens, and software used for taking notes or writing actual contracts. Other expenses such as rent, legal, and administration are common indirect costs. Salaries of those not tied to a specific project would also fall in this category.

If we refer back to our previous example, although the direct cost is clearly $100,000 (assuming no penalties or renewals), the indirect cost is far from clear and depends on the contract. In some cases, the indirect costs could just as easily match or surpass the direct cost. That’s because lawyers, paralegals, contract managers, and administrators involved in the contracting process need to be factored in. Not to mention, there are other elements such as software, compliance checks, data security, and even business reputation maintenance.

That’s why if not carefully monitored, contract costs can spiral out of control. The more elements and individuals involved, the higher the indirect costs, which is how having a good CLM system is a reliable way to control the price of contracts.

Free guide ‘Smart Hacks: How to Speed Up Sales Cycles’

Grab my copy

Costs of Creating Contracts

To better understand how CLM software can generate significant cost savings, here’s an overview of how indirect contract costs are incurred during 9 stages of the contract lifecycle:

Contract request

This stage is somewhat self-explanatory. In order to make a contract request, someone needs to actually make the request for a contract to be drawn up. The person is then compensated for the time and effort spent making the request.

Authoring

Not only is money charged for the time spent authoring the contract, but if a template needs to be created, time is also spent for that. Then there’s the work of the individual(s) responsible for authoring. This could take the form of a lawyer charging an hourly rate, a proofreader billing by word, or an auditor’s fee.

Negotiations

Inevitably, negotiations increase the cost of a contract. Organizations reported that the more complex the contract, the higher the final price tag. A low-risk contract might be under $10k, but mid-complexity could easily be 2x-3x that, while highly complex agreements can result in sums over $100k.

Prices can skyrocket if there’s a massive sense of urgency. The more critical or time-sensitive the contract, the more money spent. One possible reason for this is because if contracted negotiators are told to prioritize a certain contract’s negotiations, this will lead to a premium being charged. It’s the same principle as if you were to send a high-priority package internationally.

So why do businesses accept such premiums during negotiations? If negotiations take too long, this could cause a project to be delayed or a deadline to be broken, which may trigger financial penalties. Furthermore, these negative effects result in additional indirect costs as roadmaps need to be revised and schedules adjusted.

Approval

Once contracts are authored and negotiated, they need to be approved. But the contract approval process requires numerous parties, departments, and stakeholders. Collecting all approvals is highly time-consuming due to the lack of organization (too many cooks spoil the soup?). Since everyone has their own opinions as well as their own stakeholders, there are lot of opportunities for honest mistakes. This might include sending an older version of a contract or erroneously omitting a stakeholder’s email from the list of recipients. But these mistakes lead to time being wasted, which in turn wastes money.

Execution

If all previous stages were handled well, then executing the contract should be simple. However, some difficulties (*cough cough* costs) that can occur involve parties being in different parts of the country or world, broken signing deadlines, and pre-execution obligations. If a business trip is required to sign the contract, money gets spent. The same holds true if the contract needs to be printed, signed, then mailed (although these costs are fortunately cheaper than an entire business trip).

Obligations management

Contracts are essentially a collection of obligations that both parties commit to. Consequently, poor management of those obligations and the failure to properly administer contracts is a major reason for legal disputes. The more complex the contract, the more complex the obligations, and the more complicated the management. And – you guessed it – this leads to major costs.

Contract amendments

Changes to anything in the original contract’s terms, clauses, sections, or definitions incur similar costs as many of the previous steps. Someone has to request the change, author the change, negotiate the change, and execute the change. In other words, all the costs of earlier stages are repeated once again. Unfortunately, there’s no way to avoid these costs as amendments are a natural step to the contract creation process. All that can be done is to find a way that helps control expenses.  

Audit and reporting

Stakeholders should receive frequent reports that explain how contracts are being executed. It’s also good practice to review contracts on a semi-regular basis to ensure compliance with industry requirements and government regulations. Performance analyses at this stage also identify if there are critical issues to address. All this, however, is easier said than done.

It’s believed that most contracts are stored on personal laptops. Not only does this present a security risk, but it contributes to massive disorganization. If there’s no central repository for documents, then there’s no ability to quickly search documents and retrieve information. Instead, what occurs is a fiasco of messaging and time spent trying to track down who has which contract, who received which report, and so on. To add injury to insult, the more documents change hands in this way, the more likely a security breach.

Renewal and/or termination

Continuous monitoring ensures that companies won’t fail in their commitments to customers if vendors miss deadlines or suppliers fail to renew on time. Such situations can result in a 10% to 20% increase in indirect costs. 

How CLM Controls Price of Contracts

At its most basic, CLM software digitizes contract lifecycle management and helps optimize processes. But more advanced options include AI, importing contracts, flagging risks, and managing obligations. Thanks to these added functions, CLM is able to significantly reduce costs for many of the contract lifecycle stages. Here’s a step-by-step breakdown of how:

Get our guide ‘Choosing the Right Contract Management Software’

Explore the essential features, less obvious things to look out for, KPIs to evaluate software performance, and most common CLM-related misconceptions.

Grab my copy

The Curious Case of Elvis Dumervil

When discussing how CLM can help control the price of contracts, it’s easier with the help of a real-life story.

Consider the situation of the former NFL football player Elvis Dumervil in 2013. His contract specified that if he were on the Denver Broncos’ roster at a certain time on a certain day, his $12 million salary would be fully guaranteed. Denver, however, wanted to sign a revised contract that would lower his salary and save the team several million dollars. 35 minutes before the deadline, both parties verbally agreed to a new contract.

However, verbal agreements aren’t legally binding. For the contract to take effect, it would need to be signed within those 35 minutes.

But with Dumervil in Miami, Dumervil’s agent in Philadelphia, and the Denver office in Denver, signature logistics became very tricky. And with time ticking, the signed contract failed to be signed and submitted on time (apparently the culprit was a temperamental fax machine). 

As a result, a chain reaction of legal actions was triggered:

1. Denver released Dumervil;
2. Denver lost about $5 million in “dead money” against the league’s salary cap;
3. Dumervil became a free agent without a team;
4. Dumervil fired his agent;
5. Dumervil’s agent was suspended and fined by the Players’ Association.

What’s the moral of the story? Aside from waiting until the last minute to finalize negotiations and leaving fate in the hands of an outdated fax machine, this entire sequence of events could have been avoided with a modern, centralized CLM platform and legally binding e-signatures. All that would’ve needed to happen is once both parties agreed on a revised contract, they log in and sign. And if a physical version were needed, the parties could meet at a later date.

Conclusion

There are a lot of ways that CLM software can control the price of contracts and generate financial savings. If you’d like to approximate how much your organization would save, calculate the average cost of your contracts. Then, in order to factor in the effect of CLM, estimate that your contracts will progress through these stages 80% faster. This will give you a rough number.

Compared to the average company, efficient businesses are able to cut about 33% of their contract costs with the help of AI-equipped CLM software. Although MSAs are very useful, an effective CLM platform may be more likely to come in handy. If you’re looking for ways to control the price of your company’s contracts, book a free demo and learn how AXDRAFT can help you.