Digital, Commerce & Creative 101: An overview of Open versus Closed Book Contracts and our 5 tips for success!

1. What is an Open Book Contract?

An open book contract, also known as a ‘cost-plus’ contract, is different to a closed book contract in two key ways: it provides the customer with visibility of the supplier's (relevant) financial records related to the cost of providing the services; second, it uses a charging structure based on the actual cost of the services plus a fee for the supplier (e.g. actual costs plus 6% management fee).

This transparency allows the customer to:

• scrutinise costs and the supplier’s profit margin, and ensure fair pricing
• identify areas for cost saving/efficiency, and influence what costs are incurred, where and when (including on assets and personnel) – there is often a balancing act between service levels and cost.

2. When are the Key Differences with Closed Book Contracts?

While open book contracts emphasise transparency and cooperation, in a closed book contract the supplier's financial records are (typically) not disclosed to the customer.  The customer pays a fixed price or rate, and there is no visibility into how the costs are derived. This can lead to less trust and potential cost inefficiency. 

On occasion, customers with a strong negotiating position use ‘closed book, open view contracts’, which can be pretty challenging contracts for suppliers to operate profitably. 

3. When are open book contracts used?

Open book contracts are commonly used in service areas/sectors where transparency is key such as:

• IT 
• Logistics 
• Construction
• Manufacturing
• Healthcare
• Government contracts (where public accountability is also key)

They can also be used where the customer requirements are not certain at contract signing or are too complex for the supplier accurately to price at service commencement. 

4. What can go wrong with open book contracts?

• Lack of active governance: open book contracts need time and resource to review and challenge supplier spend. Most customers fail to allocate the resource to manage these contracts, which can lead to weaker operational and financial performance
• Trust & Collaboration: if either party is not transparent, it can lead to mistrust and conflicts. 
• Cost Overruns: without robust contractual controls, costs can easily escalate, with suppliers stating that the ‘cost are the costs’. If the contract is not carefully structured, the supplier may be incentivised to overspend as it can spend its way to meeting service levels/KPIs and/or it may receive a bigger management fee (where that fee is calculated as a percentage of actual spend). 

5. Our Top 5 Tips for Successful Open Book Contracts

• Try to design a financial structure that creates a win-win for both parties. 
  • The supplier needs an upside, e.g. a gainshare mechanism in which it stands to be paid a portion of any savings made
  • Identify who bears any cost overrun if actual costs exceed the budget – this will usually be the customer, but the management fee (and any gainshare) can be structured in a way to share this risk
  • Use granular cost categories in the budget, not large buckets of cost!
  • Ensure base (year 1) costs are known before adopting an open book model, otherwise there may ‘fat’ in the budget (using open book with a new supplier is generally risky – much better first to get to know the supplier and how it operates)
  • Identify which costs should be excluded from the management fee, e.g. fuel costs otherwise the supplier may benefit from an increase in fuel duty
  • Scrutinise the customer’s share of fixed costs/overheads
  • Be careful if fixed costs are specified as a percentage of variable costs e.g. if a fixed cost (e.g. customer’s share of insurance) is listed as €0.10 pc but volumes are 50% higher than budgeted, the insurance cost to the customer goes up by 50% but the supplier may have incurred no increase in insurance premium  
• Every obligation on a supplier generally attracts a cost of compliance for the buyer (whether personnel, asset or out of pocket cost): so, try to ensure this cost is allocated; and identify ‘excluded costs’ that should be borne by the supplier, such as:  
  • expenditure outside of the budget that has not been justified and approved by the customer 
  • employee-claim costs (e.g. slips & trips or unfair dismissal costs) that would not have arisen but for the supplier’s failings
  • central/head office/back office costs that are already factored into the supplier’s management fee
  • insurance policy excesses where claims are made due to the supplier’s failure
• Avoid using open book with ‘black box’ products or where third parties are used, where you cannot easily verify value for money
• Take your time to design and negotiate a comprehensive open book contract – taking the time to ask the right questions, discuss (and not side step) the tricky (‘what if') issues and articulate practical solutions will save time for both parties in the long run and minimise the risk of a (potentially expensive) dispute.
• Actively police your contract: FDs should allocate budget for a designated contract manager, and, ideally, the person who will be managing the contract should be involved in contract negotiations.