Tactical to Strategic: How Smart Contracts Are Turning Supply Chains Into Value Chains
Prevalent AEC (architecture, engineering, construction) and EPC (engineering, procurement, construction) contracting models, from the prime contract through all the flow downs across the supply chain, are notoriously wasteful. With informational and transactional friction between the counterparties of each contract, massive administrative redundancies and distrust has hardened the relationships between players in the ecosystem.
This burden is compounded from project to project as the contracts effectively start from ground zero for each project, with little continuity or performance history to drive and capture efficiencies. The result is an entire sector locked in cyclical, paper-based workflows that bear an astounding hidden cost: up to 40% of the total cost of each project.
In the past year, this outmoded way of designing and constructing buildings, plants and infrastructure is beginning to wane as companies embrace greater digitization. Amid a pandemic where increasing market pressure coupled with navigating COVID-19 restrictions has forced many companies to accelerate digital transformation efforts to fundamentally shift business processes and crush both capital and operational waste. Just as the design and construction industry have focused on automating design and the physical processes of fabrication and construction, new technologies are set to enable the automation of business processes related to contract execution and administration.
Data Makes a Difference
Business processes, however, require something quite different from design calculations and the physical elements of construction. Business operations require event data that has historically been provided through observation and manual input by humans relying on multiple sources or independent verification. For contracts and purchase orders in the construction industry, this data is spread across a diverse ecosystem of companies with an enormous range of digital capabilities. Unfortunately the data needed to inform streamlined businesses practices is often siloed and protected behind contractual language and other system firewalls.
General contractor (GC), construction management (CM), AEC and EPC firms independently develop and manage their contractual relationships to direct and coordinate the physical activities involved in engineering/design, procurement and construction stages. With the right technology infrastructure in place alongside digital processes, these parties are in the pole position for mastering data and information across that same ecosystem to automate contracts across their supply chain.
While automating all contracts across a supply chain may sound analogous to eating an elephant, the technology to do so exists and it is possible to take a low cost, low effort, iterative approach to tackle this challenge.
What’s More Practical than a Contract?
Admittedly, contracts are far from practical. But as it stands, every single company involved with the design and construction of any asset must form, execute and manage a contract. At its core, commercial terms of a contract (and its attachments) define the scope of product or service to be provided by the seller, determine how the delivery of that product or service will be verified by the buyer, and ultimately, how the buyer will compensate the seller when the contract conditions are met. Sounds simple enough, right? Unfortunately, there is one glaring obstacle: a lack of trust.
The lack of trust between a buyer and seller introduces significant complexity in the second step; verifying that the buyer has received what they agreed to pay for. In construction, this becomes a challenge due to the sheer scale of the activities and resources necessary to design and construct a building, an industrial plant or an infrastructure project like a road or bridge. In addition, the high project costs and length of time to complete should be considered.
These factors raise the risk of construction projects and the contract is where risk sharing often takes place; where the complexities of verification, incentives and penalties, and payment terms are introduced and nailed down.
In response to the high-risk profile and lack of trust between parties, the industry has devised an array of contracts to try to deal with the situations only to contribute to ever-growing claims and disputes and other costly invoicing mistakes, where whole groups are dedicated to preparing, analyzing, disputing and correcting invoices.
In addition, contract administration and invoice processing workflows are largely paper-based, with human beings still having to verify and then manually input, paste, check-off, or e-sign in one system or another. Then there are multiple sources of truth or verification derived from siloed data finished with sluggish human review/approval processes.
Moving to Smart Contracts
Smart contracts, using readily available data and backed by immutable blockchain technology, provide a simple, inexpensive solution to construction’s Gordian knot. In a wide range of service and performance contracts, a smart contract codifies existing natural language contract terms between parties, then taps operational field data and Industrial Internet of Things (IIoT) connected devices to verify in real-time, exactly what happened and where. This becomes the mutually agreed, independent, automated, single source of truth that directly addresses the verification challenge.
With data, the smart contract determines that pre-agreed contract terms have been satisfied, then it triggers automated payments removing invoice process burden, accounting reconciliations, contract claims and disputes, and other elongated business processes that destroy value and breed distrust. All source data and transactions are stored in a private and permissioned blockchain that allows participants to retain fully transparent and auditable records. Essentially, smart contracts solve for long standing, persistent industry issues by supplying trust and efficiency through the automation of contract administration and invoicing processes.
The Step Toward Tactical
To take a step toward tactical, parties can begin with a single contract and a willing partner, with whom invoice processing has been a challenge and errors and disputes are common. The last stipulation is that electronic data must be available to verify conditions of the contract. This data can come from the buyer and/or the seller or even a third party as long as the parties agree that it is a reliable source of truth. From there, automating the business processes in a way that is trusted by both parties is a straightforward, three-step process:
- The data is brought into an Industrial Internet of Things (IIoT) platform where it is mapped to a data model referenced by the smart contract and stored.
- The smart contract uses the stored data to confirm that the conditions of the contract have been met. The smart contract then applies the appropriate modifiers and pricing to create charges, and accumulates the charges for invoicing.
- The blockchain records all of the transactions and supporting data in immutable blocks that are identically distributed to the contractual parties. From there, the preparation, submittal, approval and payment of the invoice becomes touchless -- because it has been validated by the smart contract with immutable records on the blockchain.
Once the business process automation of the first contract is put into practice, the light bulb goes off and everyone (operations, procurement and supply chain, accounting and IT) will see where simple process automation can work including the huge burden it can lift from an organization - all done with minimal investment and resource commitment.
With the first contract automated, it’s time to move from tactical to strategic. It’s time to evaluate which contracts more readily lend themselves to automation and which will require more effort.
- What are the big bucket priorities (revenue or spend)?
- What buyers or sellers are willing or capable of working to automate contracts faster?
- How does automating the business processes of your customers or supply chain fit into your company’s digital transformation strategy?
- How can digital thinking be applied to your existing natural language contracts full of paper-based, manual verification requirements?
- How will customer or supplier relationship management change when there is full transparency and an immutable history of performance?
- What type of decision support can be developed utilizing quality data that is specified by contracts?
- Can the data utilized by smart contracts help automate corporate ESG reporting and audits?
- How can smart contracts be used to simulate business operations and forecast financial performance?
With these questions, a world of possibility suddenly opens up. In construction, the processes follow the money and everything from culture to scope to execution flows down from the owner. But the owner normally relies on the GC, the CM, the AEC, or the EPC to bring their plan to reality. These firms are the linchpin of constructions’ endeavors and a project’s success or failure is most often attributed to their ability to organize and manage diverse activity across a complex ecosystem of companies.
In today’s increasingly technology-reliant world, these firms can be the masters of their ecosystems. It is time that they embrace their true role and lead the digital transformation of the industry. By offering a new approach that builds trust, mitigates contract waste, and eliminates administrative burdens, a commercial network will emerge that puts data owners in the driver’s seat, capable of operating with certainty as a base across the full spectrum of contracts in construction’s supply chains.