A New Approach to Contracts

In an era when businesses increasingly have to depend on their suppliers to lower costs, improve quality, and drive innovation, traditional contracts don’t work. They often undermine the partnerlike relationships and trust needed to cope with external uncertainty.

The remedy is to adopt a totally different kind of arrangement: a formal relational contract that creates a flexible framework designed to foster collaboration in complex strategic relationships over the long term. These contracts, which are legally enforceable, specify mutual goals and establish governance structures to keep the parties’ expectations and interests aligned.

They are especially useful for complex purchasing arrangements, outsourcing, strategic alliances, joint ventures, franchises, public-private partnerships, large construction projects, and collective bargaining agreements.

Crafting a formal relational contract involves five steps: laying the foundation, cocreating a shared vision and objectives, adopting guiding principles, aligning expectations and interests, and creating systems for staying aligned.

When Dell originally selected FedEx, in 2005, to handle all aspects of its hardware return-and-repair process, the companies drew up a traditional supplier contract. The 100-page-plus document was filled with “supplier shall” statements that detailed FedEx’s obligations and outlined dozens of metrics for how Dell would measure success. For nearly a decade, FedEx met all its contractual obligations—but neither party was happy in the relationship. Dell felt that FedEx was not proactive in driving continuous improvement and innovative solutions; FedEx was frustrated by onerous requirements that wasted resources and forced it to operate within a restrictive statement of work. Dell’s attempts to lower costs, including bidding out the work three times during the eight-year relationship, ate into FedEx’s profits.

David Frydlinger is the managing partner at Cirio, a law firm in Stockholm, Sweden, and an adjunct lecturer at the University of Tennessee, Knoxville’s Haslam College of Business.

Oliver Hart is the Lewis P. and Linda L. Geyser University Professor at Harvard University and a 2016 corecipient of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

Kate Vitasek is a member of the graduate and executive education faculty of the University of Tennessee, Knoxville’s Haslam College of Business, where she leads the university’s research and courses on highly collaborative win-win “vested” strategic business relationships.