Lean contracts and cooperation

The last part in our three part series about agile development and contracts will provide a glimpse into the future by looking at how thought leaders have managed contracts to foster cooperation between companies and to create superior performance in complex environments:

Are rigid contracts needed for protection so that companies will not take advantage of each other? Actually there is another way of looking at cooperation between companies. Once again, lean pioneer Toyota provides the example to follow.

When Toyota started to cooperate with suppliers in the US in 1998 they naturally did have contracts, but contracts were not the main instrument protecting the interests of the suppliers. In a short time the suppliers developed trust in Toyota and in 1998 Toyota was ranked as the most trusted automaker by all suppliers. Toyotas ranking was twice that of GM’s. Trust in this case meant that the supplier could trust Toyota to treat them fairly and not to take advantage of them.

Toyota worked with their suppliers, making them more efficient by improving their processes, but did not demand that they would cut prices as GM is known to do. Toyota realizes that long term relationships and partnership is more important than short term gains that can be realized by pressuring suppliers.

Toyota uses target-cost contracts composed of a base cost + a calculated cost for change. If the cost is exceeded, the parties negotiate on who should pay what. But Toyota usually pays the bigger part. This gives engineers at both companies incentive to keep cost down. It also keeps transaction costs down and makes it possible for them to work together with little bureaucracy and complete transparency. Very little money is spent on negotiating and managing contracts. That is important since transaction costs dominate most buyer/seller relationships according to “Dyer, Collaborative Advantage, 91-96”.

Toyota buys 75% of their parts in the US from suppliers. US automakers buy less than 50%. Yet Toyota spends only haft as much time and money on purchasing activities. In addition to that, suppliers have better quality and are more productive in cells devoted to serving Toyota.

Another interesting application of lean thinking was when the British Airports Authority, BAA, built the new T5 terminal at Heathrow. T5 is Europe’s largest and most complex construction project to date. To avoid the catastrophic performance and the 1000 % budget overdraws of other previous similar big construction projects; BAA did not try to sell the risk to subcontractors by using fixed price contracts. Instead they used cost-reimbursable contracts with incentive for contractors to improve performance. The T5 contracts were designed to get everyone working towards a common goal. BAA took on the complete risk and the responsibility for managing and running the entire project, including all subcontractors as if it were all one big virtual company.

BAA used cost information from other projects, validated independently, to set cost targets. If the out-turn cost was lower than the target, the savings were shared with the relevant partners. This incentivized the teams to work together and innovate. It was in fact the only way to improve profitability!

In return for its goodwill BAA demanded absolute transparency in the books of its suppliers; this created an approach in which all team members were equal and which encouraged problem solving and innovation in order to drive out unnecessary costs, including claims and litigation, and drive up productivity levels.

So, it seems that there can be trust between companies after all. The strategies outlined above fits perfectly with the goals and methods of agile software development. So software buyers, no time to waste, pick up the phone and give your purchasing department a call. Tell them that you cannot afford fix price contracts anymore and that you want them to do some research on a new type of contract for your next project…

– Henrik