How to contract for innovation with your suppliers and customers – Insight Letter on Contracting in the New Economy

In an economy characterised by increasing volatility, uncertainty, complexity and ambiguity (VUCA), new approaches to contracts are needed in many of the strategically most important commercial relationships. In Cirio’s Insight Letter on Contracting in the New Economy, we share ideas and insights based on years of experience from assisting our clients in establishing contractual rules of the game to face this challenge. In this Insight Letter, we focus on innovation.

There is a standard way to contract for innovation with customers and suppliers, which in our experience never or rarely works. To contract for innovation, a broader perspective on both innovation and contracts are needed. Here are a few tips.

Innovation is critical for all organisations to gain and keep competitive advantages. To cut costs, to improve on sustainability, to develop new products or services, to increase customer satisfaction and for other reasons. While many organisations have innovation as their organisational DNA, others are to an increasing extent looking outside their organisational boundaries to dig into the competence and expertise of others. Hence, it becomes necessary to contract for innovation.

A traditional outsourcing or supply chain agreement will not seldom include the innovation clause. The innovation clause typically says something as follows:

If the supplier suggests ideas for innovation that saves costs for the supplier, the supplier will be entitled to 50 % of the savings, should the customer, in its full discretion, choose to implement the innovation or improvement idea.

Very few organisations have seen success in innovation with such clause, and if they have seen success, it is typically in despite of and not because of the clause.

In order for innovation to happen between the contracting parties, the parties need to ensure that they can tick three boxes:

• The parties must be able to answer the question “Innovation for what?”
• There must exist proper economic incentives for innovation.
• The parties must have appropriate mechanisms in place regarding governance of innovation.

The standard approach to innovation, exemplified in the clause above, does not meet these criteria. That innovation is needed to cut costs is clear (innovation for what?). But often, organisations want innovation for a number of other reasons. Today, innovation to improve sustainability is becoming more common. Thus, the clause is too narrow in its scope.

While 50 % of the savings may provide the proper incentives for innovation, it typically does not. Most contracting parties use a transaction based economic model where the supplier is paid for activities. An innovation will often lead to improved efficiency and therefore fewer activities. Hence, the supplier will often lose more money than they gain from the 50 % of the savings.

Finally, the standard approach totally misses the fact that innovation is not something that only takes place at the supplier’s offices. Rather, innovation is the product of jointly governed innovation processes established between the parties, with clear roles and responsibilities. In our experience, lack of proper governance is often the main reason why innovation does not happen in customer/supplier relationships.

Innovation will thus typically only take place under contracts where the parties have clear common goals and objectives to pursue through innovation, where the economic incentives for innovation are aligned and clear governance processes exist. These characteristics are rarely found in most traditional customer/supplier agreements.

Questions for you to think about

• What is your organisation’s approach to contracting for innovation?
• Do your contracts tick the three boxes listed above?
• How can you update your contracts to increase the level of innovation in your customer/supplier relationships?

We hope you find this Insight Letter valuable. For more information regarding this subject, please feel free to contact: