What Is Contract Economics? Definition and Principles

Contracts play an important role in business transactions. So how do you make sure your contracting process is efficient? 

Legal fees and time spent drafting are only two factors that contribute to contract costs. What about constantly changing business priorities, or loss of efficiency as a poorly designed or loopholed contract drags on? 

This is where a better understanding of contract economics can help. Following contract economics practices let you address contract cost leakage at the roots and improve your ROI. 

Sounds good? Here’s what you need to know. 

What is contract economics?

Contract economics is the study of what adds or reduces the cost of the contracting process. It also shows how you can measure and optimize your contracting processes.

As an analytical method, contract economics covers the entire spectrum of contract management, from initiation and creation to termination or renewal. In addition, contract economics allows you to assess contract visibility and compliance. In this way, you can ensure that there are no gaps at any stage and a contract fully fulfills its purpose.

It’s easy to overlook how contract management affects revenue. In fact, World Commerce & Contracting research shows that poor contract management procedures cost companies a massive 9% of their annual income.

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There are several ways you can avoid such high-cost leakage:

  • Calculating expenses incurred when concluding, discussing, negotiating, renewing, and terminating contracts
  • Monitoring the progress of negotiation and possible delays and trying to identify their cause
  • Identifying contracting risks and coming up with options for their reduction

This is exactly what contract economics is all about. Let’s look at how it works in practice. 

What are the principles of contract economics?

Most of us associate terms like “economics” and “analytical method” with tedious work. In reality, analyzing your contract economics can become an enjoyable process full of insights. 

Simply apply these key principles:

  • Contract provision analysis. In-depth contract analysis helps you identify problem provisions such as incomplete obligations, missing warranties, and blurry rights or interpretations. All these things can increase contract revisions and delays, leading to higher contract costs.
  • Close monitoring of contract renewals. It would be great if contract renewal was as simple as clicking a “renew” button. In practice, things are rarely so easy. Something has certainly changed since you last signed a contract. Closer contract monitoring involves reviewing and updating information in an agreement before it’s renewed, which saves you time and money when the renewal date arrives.
  • Contract cost control. This involves identifying all expenses associated with your contracts, from employee salaries to wasted resources. Contract lifecycle management (CLM) software can be a lifesaver here, but you need to ensure it does its job completely and that you’re not overpaying for services that don’t work for you.
  • Tracking of contract management ROI. Your contract management ROI is a legal performance metric that reflects the efficiency and profitability of your contracting process. A low ROI is a sign that you need to take action. For example, rethink the productivity of your staff, pay attention to contract risk management, and generally review how automated your legal activities are. 
  • Tech adoption. For most contract management issues, automation is the answer. A reliable CLM system makes it easy to monitor renewal dates and track the fulfillment of contract clauses to avoid fines and penalties. 

As you can see, following the principles of contract economics is no more complicated than monitoring legal metrics. Together they can work even more miracles.

Measuring the vendor fraud metric, for example, helps you calculate the personal benefit suppliers gain from submitting incorrect amounts on invoices. It’s great if you have full confidence in your partners, but in some cases, however, suppliers may add value for no reason. 

No one is immune from defective inventory either. Measuring quality is vital to make sure you don’t suffer losses from defective products. If you provide services instead, this metric is also useful – just evaluate the rate of complaints and the time it takes you to resolve them.

If you suspect something is amiss with your suppliers or other partners, take a look at the annualized contract value metric. It will help you assess the value of your current contracts and decide whether these relationships are still profitable. 

In short, incorporating contract economics principles into your operating model along with legal metrics will help you avoid lost revenue and keep your day-to-day operations running smoothly.

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Conclusion

Contract economics isn’t just a theory with boring analysis and complex formulas — it’s a set of empirical principles you can apply daily to improve your contract management ROI. Essentially, it highlights the importance of 

  • Double-checking all contract provisions
  • Reviewing contracts before renewal
  • Tracking relevant KPIs
  • Understanding and closely monitoring where your expenses lie

If you’re a large organization that works with different contracts on a daily basis, how can you do all these things? Whether you’re struggling with low contract management ROI or need to monitor compliance with obligations to avoid penalties, CLM software is the logical answer.

AXDRAFT’s CLM helps reduce contract management expenses and streamline workflows with top-notch reporting and analytics. Discover its advantages today with a free demo

FAQ
What’s the basic definition of a contract?

A contract is an agreement between parties to do or not do certain things that is legally binding (i.e., it creates legal obligations for parties) and enforceable (i.e., parties can be made to obey its terms).

What is a contract, and what are some examples?

A contract is an agreement between parties that legally establishes their relationships and mutual obligations.

 

Some common examples of contracts in business are fixed-price, cost reimbursement, cost-plus, time and materials, unit price, bilateral, and unilateral contracts.

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