A Guide to Concentration Risk for Contract Managers

The general course of doing business can expose an organisation to a wide variety of risk scenarios. Without a clear understanding of why, how and where these risks originate, it can be a struggle to effectively prevent, mitigate or respond to them.

Concentration risk is associated with the potential danger and vulnerability an organisation might face through excessive dependency situations.

This type of risk can occur in a number of forms, with different origins, triggers and effects. Overreliance on anything is highly susceptible to unexpected challenges or failures.

An organisation’s contracts with its vendors and customers provide a fertile breeding ground for concentration risk. The likelihood of its current existence in some form with respect to those contracts can vary, as might its effects and general awareness of the latent threat.

Contract Managers should be highly interested in concentration risk because it can directly impact the overall success of the contracts they oversee.

Such risk must be identified and managed as a standard component of contract management processes to ensure the organisation's contractual arrangements are resilient and well-balanced.

Common Forms of Concentration Risk

This article describes concentration risk as it relates to contracts, the concerns they raise, and how they could be addressed for the following common forms of such risk:

• Contract terms
• Currency
• Customer
• Date
• Geography
• Industry/sector
• Key personnel
• Regulatory compliance
• Supply chain
• Vendor

A summary of the part Contract Managers can play in identifying and dealing with concentration risks within their purview is also provided.

Contract terms concentration risk

A significant number of an organisation’s contracts with customers and vendors can have similar or standardised contract terms.

When such contracts have multi-year durations, and/or in times of substantial change and turmoil, such terms can easily become no longer fit for purpose, raising risk levels across many contracting aspects like:

• Adaptability: contracts with rigid, uniform terms might not adequately address changing business needs or evolving regulatory requirements, potentially leaving the organisation exposed to risks or missed opportunities
• Difficulty of Renewal or Extension: contracts may not be renewed if the organisation insists on use of its unsuitable standard clauses, or negotiations might be protracted or fail
• Performance expectations: standardised terms might not fully reflect the unique requirements or deliverables for each contract, leading to misunderstandings and disputes over performance expectations.

Approaches that can help address these concerns include:

• Challenged clauses register: maintain a log of all customer or vendor objections to standardised contract terms received during negotiations, and the reasons behind any instances of those clauses creating difficulties in active contracts. Prepare alternatives to known problematic clauses for use if needed
• Negotiation strategy: determine thresholds for introducing alternatives to known problematic clauses if they get challenged during contract negotiations
• Relevance review: examine all long-term contracts at least annually to assess and update as necessary the fitness of standardised terms for current operating conditions and risks, and for meeting any regulatory compliance obligations
• Standard clauses fitness review: conduct regular reviews of the relevance and adequacy of the organisation’s clause standards and adjust as needed.

Currency concentration risk

Where many of an organisation's contracts involve transactions in just a few foreign currencies, particularly for large amounts, exchange rate volatility can pose several concerns, including:

• Creditworthiness: foreign exchange rate movements can significantly impact the credit rating of an organisation’s customers and vendors if they become financially stressed due to currency volatility
• Hedging costs: using hedging instruments to mitigate foreign exchange risk can be administratively complex and incur additional costs
• Pricing and competitiveness: exchange rate fluctuations may make the organisation's products or services more expensive for customers in foreign markets
• Volatility: sudden currency movements may result in increased vendor costs for the organisation, or reduce the value of revenue earned from foreign customers.

These concerns can be dealt with using the following strategies:

• Diversification: aim to diversify revenue streams and the vendor base across multiple countries and currencies to reduce any reliance on a single foreign currency
• Currency clauses: include currency adjustment clauses in contracts that allow for periodic revisions of prices or payment terms based on exchange rate fluctuations
• Long-term contracts: consider negotiating longer-term contracts with vendors and customers to gain the benefits of smoothing effects and provide stability and predictability amid currency volatility.

Customer concentration risk

A heavy reliance on a few key customers, or worse, just one, for a significant portion of its revenue should make an organisation very afraid. The concerns it is likely to have in such a situation include:

• Bargaining power: key customers can demand more favourable terms or lower prices from the organisation, squeezing its margins and profitability
• Business downturn: sudden loss of a key customer, especially if it owes the organisation considerable sums, can threaten the organisation’s prospects
• Demand expansion: any inability on the organisation’s part to be able to finance and/or meet changed preferences, or increased volume / accelerated delivery timing demands from key customers could lead to contract termination
• Demand reduction: sudden or sustained reduction in demand from key customers can affect the organisation’s stability and financial performance, or its existence.

Organisations subject to customer concentration risk should undertake:

• Contingency planning: develop approaches to address potential revenue shortfalls in case of the loss of a key customer
• Diversification: expand the customer base to reduce reliance on a few key customers
• Regular contract review: assess and renegotiate contractual terms to ensure they remain beneficial for both parties and reflect changing market conditions
• Vendor-of-choice strategies: focus on product/service quality, customer satisfaction and various sweeteners to enhance customer loyalty and reduce the risk of losing key customers.

Date concentration risk

The more active contracts an organisation has to manage, and the more regulations it needs to comply with regarding those contracts, the greater the likelihood that some of the negotiated or mandated deadlines for completion of key activities in each area will occur on the same dates or in the same short periods.

Concerns related to this concentration risk include:

• Activity load uncertainty: lack of clarity about what activities need to be done by when, the average completion time for each type of activity, or how many instances of each activity have the same due date
• General invisibility: low awareness of the critical dates in contracts and applicable regulations, and the consequent probability of excessive loading of some dates
• Heroic efforts: the effects of date concentration on workload are typically incremental, often not really noticeable until they suddenly are when massive effort is required to ensure deadlines are not missed
• Resource allocation loads: more activities might be due for completion in the same short period than available people can reasonably undertake
• Unwanted outcomes: costs related to undesired contract renewal or termination due to failure to comply with notice deadlines, or penalties applied for contractual or regulatory non-compliance, can be severe.

The following strategies can help address such concerns:

• Activity automation: automate whatever can be within reason in the activities to reduce their duration
• Dashboards: implement readily accessible real-time visual representations of contract management and regulatory compliance activities by date and other perspectives
• Date-staggering: during contract development and preparation of contract management plans for each new contract, stagger important dates to minimise date overuse
• Key dates calendar: document all dates that should be avoided for contract management purposes
• Mitigation strategies: develop options for dealing with unavoidable date concentration
• Planning technologies: use project management or similar software for activity scheduling, identification of bottlenecks, and real-time tracking of progress against timelines
• Priority treatment: identify instances of contract management activities related to critical contracts where failing to meet deadlines must not happen
• Regular concentration risk scanning: continuously track instances of date usage beyond thresholds representing unsustainable concentration risk, and alert designated stakeholders
• Start and finish early: commence activities early and finish quickly to avoid last-minute rushes to meet deadlines
• Temporary workforce: obtain skilled temporary workers to assist during peak workload periods.

Geography concentration risk

Having many key vendors or customers located in the same geographic area can create concerns for the organisation, including:

• Business continuity: unexpected events, economic downturns, or natural and other disasters in the area may create a high risk of disruptions to the organisation’s business
• Currency fluctuations: exchange rate volatility can affect the cost of supplies and the price of the organisation products and services, potentially impacting the organisation’s profitability
• Infrastructure availability: there may only be a single viable shipping port or transportation method available for certain products, possibly susceptible to delays due to weather conditions or equipment failures, maybe charging monopoly prices
• Political, regulatory and other risks: changes in government policies, trade agreements, or geopolitical tensions can impact the local supply chain of key vendors
• Reputational impact: conducting business in the visible face of vendor non-observance of social and ethical considerations such as labour practices, environmental regulations or human rights issues in a geographic area can severely affect the organisation’s reputation.

To address these concerns, organisations should consider the following strategies:

• Contingency planning: develop contingency plans to address potential vendor location-related disruptions and help ensure business continuity
• Dual sourcing: consider dual sourcing for critical inputs or materials, where possible, to have backup vendors in different geographies ready to step in if the preferred vendor faces issues
• Market expansion: explore new markets or regions to diversify the vendor and customer bases and reduce reliance on a single geographic area
• Regulatory compliance: contractually ensure that vendors in different geographic areas comply with relevant laws, regulations, and industry standards relevant to the organisation's operations
• Risk assessment: conduct a thorough risk assessment for each vendor to identify potential risks associated with their geographic location and evaluate their capacity to meet contractual obligations
• Supply chain mapping: map the entire supply chain of key vendors to identify potential vulnerabilities and dependencies related to vendor location
• Vendor collaboration: collaborate with suppliers to understand their capabilities and jointly identify strategies to mitigate risks associated with their geographic location.

Industry / sector concentration risk

Operating mainly within a single industry / sector can make an organisation susceptible to the following issues:

• Economic vulnerability: the organisation's revenue and financial stability can be at risk due to heavy reliance on contracts within a single industry / sector that might be facing economic disruptions or downturns
• Market share dependency: losing a major customer or vendor could significantly impact the organisation's market share and profitability
• Regulatory and policy risks: regulations, policies, or government interventions specific to the industry / sector can directly impact contracts with vendors and customers. Changes in applicable regulatory environments can lead to contractual compliance issues and potential business disruptions
• Technological obsolescence: the organisation’s failure to keep up with rapid advances in technologies used in the industry / sector may reduce the attractiveness of its products and services, or its ability to compete
• Vendor and customer solvency: if the organisation’s customers or vendors face financial difficulties, it may lead to payment delays or defaults on contractual obligations.

The following approaches can help address these concerns:

• Collaboration: collaborate with customers and vendors in the industry / sector to address common challenges and explore growth opportunities together
• Customer and vendor assessment: regularly assess the financial health and stability of customers and vendors in the industry / sector to identify potential risks
• Diversification: seek opportunities to diversify the customer base and vendor network across different industries and sectors to reduce concentration risk exposure
• Industry outlook monitoring: keep a close eye on industry trends, economic indicators, and regulatory changes to stay informed about potential risks and opportunities associated with the industry / sector
• Scenario planning: develop scenario-based contingency plans to address potential industry / sector risks and disruptions.

Key personnel concentration risk

Having only a small group of key personnel like Contract Managers, lawyers and various stakeholders responsible for negotiation, oversight, and management of contracts can create many concerns for the organisation, including:

• Bottlenecks and slow decision-making: inefficient, ineffective and irrelevant but mandatory processes can lead to delays in contract negotiations, approvals and reviews, and non-achievement of agreed deadlines
• No redundancy: limits on the availability of required expertise, both planned and unplanned, can lead to delays, mistakes, and a lack of continuity in contract management
• Poor planning: schedule clashes, impossible deadlines and overlooked activities are common outcomes of inexperience, pressure and unsuitable planning tools
• Workload growth: organisations can be slow to ensure that sufficient staff are available in a timely manner to deal effectively and promptly with a growing workload, with predictable effects on activity completion rates, outcome quality, risk potential and personal stress levels.

The following strategies to provide a more resilient and adaptable approach to handling contract-related responsibilities can help address such concerns:

• Capacity planning visibility: ensure proposed workload scheduling is accessible to participants for review and feedback
• Career development: provide ongoing training, professional development and a career path for all levels of people involved in contract management activities, including project planning and management, and the use of relevant software tools
• External partnerships: collaborate with external legal and contract management experts on an as-needed basis, like during peak activity periods
• Process refinement: rationalise and continuously optimise contract management processes
• Teamwork: foster communication and collaboration within and between teams involved in contract management activities
• Technologies: implement appropriate software tools to support and automate the planning and performance of contract management activities.

Regulatory compliance concentration risk

An organisation that has a large number of active contracts to manage and is subject to a range of regulatory obligations related to its contracts might have to deal with concerns like the following:

• Conflicting obligations: different regulations may require different approaches to similar obligations
• Contract assessment: time and resources required to discover which contracts must comply with which regulatory obligations
• Cost of compliance: time and resources needed to manage the compliance activities across the contract fleet and the applicable regulations
• Lack of expertise: difficulty determining which obligations in each applicable regulation actually need to be complied with can enhance the risk of penalties for non-compliance.

Approaches for addressing these concerns might include:

• Clause library maintenance: create and keep updated standardised clauses to describe the need for compliance with each applicable regulation
• Map regulations to contracts: maintain a cross-linked list of which regulatory obligations apply to which contracts
• Obligations compliance actions: break down every applicable regulatory obligation into the steps required for achieving its compliance
• Track regulatory change: monitor changes to each applicable regulation and contractual obligation, and prepare plans for accommodating any changes that apply
• Track regulatory obligations: extract, centrally record and make accessible details of applicable obligations from each applicable regulation.

Supply chain concentration risk

Any supply chain that relies on a single sub-supplier at any level raises the following concerns for every organisation in the chain above that sub-supplier:

• Lack of innovation: the sub-supplier might be resistant to continuous improvement
• Limited bargaining power: the sub-supplier exhibits take-it-or-leave-it tendencies
• Quality and compliance issues: the sub-supplier lacks the wherewithal to produce the desired quality or comply with applicable regulations
• Supply disruption: any number of issues the sub-supplier has to contend with can disrupt or halt its operations for indeterminate periods, with a domino effect on the upper levels of the supply chain.

Actions that might be taken to address these concerns include:

• Assess supply chain vulnerabilities: conduct risk assessments to identify potential vulnerabilities and possible mitigation strategies
• Develop contingency plans: make preparations for dealing with a range of scenarios that can affect supply chain performance
• Identify alternative sourcing options: locate and assess the capabilities of other sub-suppliers who may be able to replace or back-up the problematic sub-supplier
• Implement flow-down contract obligations: ensure that contracts with immediate vendors contain obligations regarding delivery and quality performance to flow down to the next level in the supply chain, to be repeated as far as possible down the chain
• Increase supply chain visibility: to the extent possible, identify the participants at each level in the supply chain that is used to obtain products of interest to the organisation
• Monitor supply chain risk: sign-up to an external service that can track and report on the risk associated with the participants in supply chains of interest.

Vendor concentration risk

Organisations with the greater proportion of their external spending going to a few vendors or just one likely has the following concerns:

• Bargaining power: key vendors can demand more favourable terms or higher prices from the organisation, squeezing its margins and profitability
• Business disruptions: if a key vendor experiences disruptions in operations, production or delivery, it can significantly impact the organisation's ability to conduct business smoothly
• Business longevity: sudden loss of a key vendor, especially if it has no viable competition or owes the organisation considerable value in unfulfilled orders, can threaten the organisation’s survival
• Demand expansion: any inability on the key vendor’s part to be able to finance and/or meet changed organisational preferences, or increased volume / accelerated delivery timing requirements, could reduce the organisation’s competitiveness in the market.

Options for addressing these concerns include:

• Contingency planning: assess the likelihood of probable and possible risks affecting key vendors that could impact the organisation, and prepare plans to deal with those risks
• Diversification: identify a broader range of potential vendors and, with a focus on minimising the potential for other concentration risks, establish contracts with the most suitable vendors
• Relationship enhancement: become a customer of choice for key vendors to gain access to preferential treatment.

The role of Contract Managers in dealing with concentration risk

Due to their expertise in overseeing and optimising an organisation's contractual relationships, and their access to relevant data, Contract Managers are well placed to play a crucial role in identifying and dealing with concentration risk to minimise its occurrence and its effects.

This can be achieved by ensuring to the extent practicable that the organisation's contractual arrangements are resilient and well-balanced, through being proactive in:

• Activity monitoring: continuously monitor the effectiveness of contract management activities to detect early signs of distress or underperformance related to some form of concentration risk, and allow timely corrective actions
• Collaboration with Risk Managers: work closely with the organisation's Risk Management team to align concentration risk assessment and mitigation strategies with the broader organisational risk management framework
• Contract development: prepare and incorporate relevant concentration risk mitigation measures directly into contracts
• Data management: collect, analyse, record and make visible and accessible the myriad pieces of data that provides clues to the potential or actual occurrence of the various forms of concentration risk related to contracts
• Diversification strategies: devise strategies to minimise the potential for occurrence of concentration risk, and dealing with it if it does occur
• Review and report: conduct regular reviews of contract portfolios to identify and address concentration risk, and provide timely and accurate reporting to senior management and relevant stakeholders
• Risk assessment: include concentration risk in the conduct of thorough risk assessments on each contract requiring management
• Scenario planning: engage in scenario planning exercises to assess the potential occurrence and impact of concentration risk events, and develop contingency plans allowing the organisation to respond effectively if such risk materialises.

These efforts can make a major contribution to the overall risk management and success of the organisation's contracts.

Wrap-up

The term ‘concentration’:

• Serves as a reminder of the potential pitfalls of overreliance on limited factors, and the importance of diversification
• Describes the level of attention many regulators are paying to this form of risk due to the possible and actual consequences of its occurrence in key areas like third-party service providers to the financial services industry, but with many others in mind
• Suggests an approach to detecting the various forms of concentration risk by focussing on hints hiding in plain sight in available data, with implications that just need to be noticed.

Tina Turner once sang ‘what you get is what you see’. That’s certainly true in many situations, but it’s often the case with concentration risk that what you get is what you don’t or can’t see until after you’ve got it.

The actual threat level of some forms of concentration risk, like those associated with overreliance on certain dates, will be incremental, tolerated until it’s too much, in a manner akin to boiling frog syndrome.

Other forms will remain dormant until triggered by a set of circumstances that hasn’t been foreseen or adequately countered contractually or operationally.

If it isn’t already on the list of usual suspects that Contract Managers have to deal with to keep their organisation’s contract outcomes safe from harm, concentration risk needs to be added. The sooner it gets the attention it needs, the better.

To learn more about how Gatekeeper can help manage concentration risks, don't hesitate to get in touch with us.