Home Sociology A short guide to contract risk

STEP THREE: REVIEW CONTRACT RISKS AND OPPORTUNITIES

After identifying the causes and consequences of risks and opportunities in Step Two, the third step seeks to analyze them to understand their nature and to prioritize them by determining their level (sometimes called the magnitude or significance), often expressed in terms of a combination of the consequences (or impact) of an event and the associated likelihood (or probability) of its occurrence. the results can be illustrated in a 3 x 3 (or 5 x 5) cube or matrix, where the impact and probability of an event are assigned high, medium and low ratings or described with numerical values, using 1 for low and 3 (or 5) for high. In connection with risks, the likelihood can be described as remote (or rare), unlikely, possible, likely, or very likely. The consequences can be described as minimal (or insignificant), minor, moderate, major, or catastrophic, leading to the risks being qualified as low, medium, high, or very high.[1]

The risk or opportunity cube (or matrix) is especially useful for prioritizing risks and opportunities for further action— for example, by accepting those risks and omitting those opportunities that are qualified as low and medium, but addressing the ones that are shown as high or very high. A sample 5 x 5 risk cube and opportunity cube are shown in Figure 6.3. The risk cube illustrates likelihood versus consequence, the opportunity cube likelihood versus benefit.

Figure 6.3 A risk cube and an opportunity cube

Using our example of a delay in delivery, we begin by assessing the magnitude of the consequences of the risk. Here, we would examine the two contracts more closely, starting with the one that we have with the customer and then repeating the exercise with the contract with our component supplier to determine what has been agreed between the respective parties (the visible terms). Where there are gaps in the contract, we also need to understand what the applicable law says about the issue at hand (the invisible terms).

When assessing magnitude, a review checklist is useful in focusing attention on visible and invisible terms. The list might be presented in the form of questions calling for a yes/no answer, as illustrated by table 6.1.

Table 6.1 Extract from a supplier's quotation/ contract review list

 Magnitude of the consequences of delay in delivery Yes No Are the consequences of delay in delivery specified in the quotation/contract itself or in the STCs that are made part thereof? Is there an effective cap/maximum for liability for delay in delivery? Is that maximum acceptable, considering the price and profit margin? If liquidated damages are agreed, are other remedies effectively excluded?

using our example, let us assume that it turns out that our contract with the customer contains a seven-day grace period but does not contain a limitation of liability. the customer is estimated to suffer a considerable loss (loss of production and high claims from its own customers) due to the delay of our delivery, and is known for aggressively exercising its rights even through litigation. In our contract with our component supplier, we realize that there is a low limit to that supplier's liability towards us. Like most businesses, we have no insurance coverage for these kinds of situations; we are on our own. It the risk materializes, there will be no profit on this contract. In addition, if the customer's claim for damages is successful, this can lead to a major loss that has a strategic impact. The consequence is thus estimated to be major and rated at 4.[2] Let us assume that the likelihood of the risk materializing—that is, our delivery being more than 7 days late—is estimated at 5 (very likely), bringing our estimated risk level (likelihood 5 x consequence 4) to 20, high priority. Table 6.2 shows an extract from a sample Risk Matrix completed from our hypothetical equipment supplier's point of view.

We would then analyze other risks—along with their causes and consequences—we have identified by using the risk matrix. Our delay example is probably among the highest- ranking risks, one that should receive a high priority. While we should have used the risk matrix earlier when planning the project and reviewing the sales and procurement documents, this process does present a learning opportunity for the future. When using the matrix as a team discussion facilitation tool, we will gain new insights into areas that need improvement.

Table 6.2 Extract from a supplier's risk matrix

 Risk Cause Impact Likelihood 1-5 Impact 1-5 Ranking Priority Delay of completion by more than 7 days Component supplier's late delivery of critical component Delay of cash-flow 5 4 20 High Misunderstanding of the time and terms of delivery Customer claims for compensation Too tight schedule Additional costs

• [1] See, for example, Mahler 2010, p. 47. In the case study conducted by Mahler,using the standard terms and conditions of a sales contract as the basis, the team's riskidentification resulted in a list of initially 88 risks, each of which was listed in a riskregister. Having analyzed and scored the risks, the list was reduced to a total of 35 risks,comprising 12 high, 16 medium and 7 low risks. The reduction was achieved by omittingthe lowest risks and those which seemed irrelevant for other reasons. See Mahler 2010, p.235.
• [2] In the case study conducted by Mahler, using a sales contract as the basis, theconsequence values were described as follows: insignificant: the influence on this salescontract can be neglected; minor: a limited reduction of this sales contract's profitability;moderate: a considerable reduction of the sales contract's profitability; major: no profit inthis contract or major loss that has a strategic impact on the division; and catastrophic:this would have a strategic impact on the company or even endanger the company'sexistence. See Mahler 2010, pp. 286-7.

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