Some Questions and Answers about Relational Contracting
For quite some time now, there has been much talk about the need for a more collaborative approach in outsourcing. In this context, the concept of relational or collaborative contracting often appears. Because of the strong business reasons to use such contracts in outsourcing deals, I think a few questions and answers on this concept would be useful for Outsource’s readers.
What is a relational contract?
A relational contract can be defined as a written contract where a continuously efficient and effective commercial relationship between the parties is given priority before the negotiated deal. The relationship is efficient when the parties cooperate without friction towards the commercial goals of the contract, i.e. when the transaction costs pre- and post-contract award are optimised. The secret to make this happen is continuous alignment of interests and the relational contract is thus a flexible framework to enable such alignment.
The relational contract must be understood in relation to the other major contract form: the transactional contract. The transactional contract focusses on the deal as it is designed at the date of contract signing. It assumes conflicting interest between the parties and the majority of its clauses are designed to deal with risks for opportunistic behaviour and not to promote continuous collaboration towards common goals. Whereas the relational contract establishes a partnership with trust and social norms as its foundation, the transaction contract establishes an arms-length relationship assuming and based on a power struggle.
When should a relational contract be used?
It is quite safe to say that in most outsourcing deals, the transactional contract is still used. So when should a relational contract then be used? Not all deals are fit for a relational contract. The transactional contract has and will always have an important role to play on the market. The choice between the two contract forms is made by assessing risk and dependency. If the contract value is high, the outsourced services are such that they have high impact on end-user experience, customer brand, volume fluctuations are frequent etc (risk) and if the customer will become highly dependent on the supplier because of high switching costs (dependency) – a relational contract should be used. It is thus quite safe to say that in most outsourcing deals, the relational contract should be used.
Why use a relational contract?
The answer to this question is simple: because it will be more beneficial in terms of revenues, costs, risks and opportunities to use a relational contract when the level of risk and dependency calls for such a contract. In those relationships, the risks for opportunistic behaviour are high and the costs arising from conflicting interest will be significant.
I think it is important here to clarify a simple fact. There is an abundance of research in economics, sociology, game theory and other disciplines that both from a theoretical and empirical point of view shows the benefits of a relational contract. It is proven beyond doubt to such degree that anyone who is thinking of using a transactional, power based, contract when in fact a relational contract is more fit – i.e. in most outsourcing deals –should be required to go to the company CFO and put forward the business case in favour of a transactional approach. A Nobel prize may be at stake here, since the research of many Nobel prize winners talks in favour of a relational contract.
Is the relational contract the same as an outcome-based contract?
No. The relational contract is a contract model where the outcome-based contract in fact is a business model: a model for how value is created and shared between the parties. The contract model and the business model must not be confused. A relational contract may in some situation be used with a transaction-based business model. However, in many situations, the best combination is the combination of a relational contract and an outcome based business model. In fact, we then land in the Vested™ model for successful partnerships, developed at the University of Tennessee.
What is the process of entering into a relational contract and what does it look like?
These questions will be answered in Part Two of this contract, i.e. in the next issue of Outsource…
This article was first published in Outsource #36 (Summer 2014).
About the Author
David Frydlinger is a lawyer for Lindahl law firm in Stockholm, Sweden, focussing on outsourcing and other strategic contracts. He also teaches Collaborative Contracting at the University of Tennessee and is a Certified Deal Architect of the Vested™ model for successful partnership.