Total Cost Issues in Contract Terms

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Total cost issues are in almost every term and each term affects one or more cost issues.

CONTRACT TERM	COST ISSUES
Delivery term	Freight costs, Risk of loss, Duties other potential charges
Delivery Point ownership / risk of loss	Insurance costs, Losses
Payment period	Cash outlay, Time value of money
Advance Payments	Cash outlay, Time value of money
Minimum buy quantities	Inventory cost
Late payment charges	Cash outlay, time value of money
Electronic / wire transfers	Time value of money, Processing costs
Changes	Price, Obsolescence, Process costs and Scrap, Increased quality and inspection costs, Impact to production if not equal. Costs of re-work and recall if discovered after the fact, Cost of re-qualification or redesign to replace with an alternative if not equal.
One time NRE charges	Cash outlay, time value of money
Premiums for Materials pull in (requests shorter than lead time)	Cash outlay, time value of money, premium costs.
Lead times and standard flexibility	Inventory Cost
Reschedules or cancellations	Cash outlay, inventory costs, obsolescence
Excess/ Obsolete material disposition	Costs or cancellations, restocking, administrative costs, sales or re-brokering commissions, reduced value of materials etc.
Cancellations	Same issues as excess/obsolete above
Warranty scope	Warranty costs (returns, repairs, test, package etc) plus associated costs (re-work if populated on a board, costs of board replacement if re-work is not possible).
Warranty length	Warranty costs
Warranty exclusions	Warranty costs
Warranty response period	Spare parts inventory cost
No defect found charges	Cash outlay
Termination for cause	Dollar damages liability, inventory obsolescence, costs
Termination for convenience	Inventory obsolescence, costs,
Indemnification and IP Indemnification	Dollar damages liability, time value of money for payment.
Limitation of liability	Limit on direct damages for all potential causes unless otherwise specified
Insurance	Cost of insurance (claims affect rates)
Definitions	Definition of cost terms like direct cost, manufacturing value added, overhead, profit, that define the cost items. Risk based cost factor, where the failure to properly define an item may impact the responsibilities of the parties, who pays for certain costs associated with the item, etc.
Statement of Work, Specifications	Determines the cost of the product. Presents a cost risk is incomplete or inaccurate specifications exist. Cost is the potential for change, and the cost of changes, re-work, or scraping, what had been done.
Term	While time doesn’t impact cost, costs can be impacted by the term and if you are locked into a Supplier, you want a term that provides you price protection.
Liquidated  damages	Liquidated damages limits the amount of cost you may recover for a problem to the agreed or liquidated amount..

While Buyers may think of contracts as a lot of legal “mumble jumble”, what contracts really do is define which party is responsible for performing certain tasks (which have an associated cost) and which party must assume certain risks (which may also have a cost associated).  For example if you agreed to “EX Works” or "FOB Origin" delivery terms you have assumed responsibility for the following costs:

·       Shipment from the Supplier’s plant to the port

·       Export clearance from the country.

·       Shipment from the Supplier’s country to your country

·       Import clearance and duties at your country

·       Shipment from the import location, to your site.

In addition you have also assumed risk for any loss or damage in-transit from the time it leaves the Supplier’s dock until it arrives at your dock and if it lost or damaged that’s a cost to you, or you have also needed to assume the cost of insurances required to protect against that risk of loss. From a cash flow perspective, your responsibility for payment is normally calculated from the time that the Supplier ships the product, not when you actually have it, so it also cut into the value of your payment terms.

Each responsibility has a cost associated with them. The risks you assume will either have a cost associated with any actions you take to manage the risk, such as buying insurance to cover against loss or damage in-transit. If you don’t assume the cost for managing those risks, you wind up self-insuring against the risk and, if the risk occurs, you will sustain a much greater loss. If companies elect to self-insure, they may still add costs to reduce the risk, such as controlling the carriers that may be used, or specifying packaging requirements and materials, both with the intent of reducing the potential of in-transit loss or damage. In some instances the costs may not be visible to you. For example, when you purchase insurance, the rate that you pay is based on your claims history and risk. The more claims you have, the greater the rate you will pay. When you agreed to assume certain risks rather than have the Supplier assume them, you are potentially impacting the claims that may be made against your insurance, which can impact the rates you pay for all items you insure. 

Where would you use the Time Value of Money and Cost of Inventory, Cost of Quality and Life Cycle Cost calculations?

• To evaluate bids from Suppliers where the payment terms quoted vary significantly.
• When a Supplier quotes a requirement for advance or early payment terms.
• When a Supplier offers extended payment terms versus other Suppliers to understand the total cost impact.
• When the Supplier’s requirements would force you to carry un-necessary inventory (e.g. guaranteed volumes, take or pay requirements, lot size, minimum volume or minimum order requirements, less flexibility on cancellations or rescheduling, etc.).
• When the Supplier’s performance forces you to carry un-necessary inventory (e.g. quality problems, delivery problems, field failures and reliability problems)

From a negotiation perspective what you do is:

• Talk about requirements or performance in terms of real dollars.
• Highlight how their terms are impacting them from being competitive under a total cost perspective (using a value of money or cost of inventory analysis).
• Highlight how their performance is impacting them from being competitive (under a total cost perspective using a value of money or cost of inventory analysis).
• Show them that to get or keep the business they need to change both to be competitive, or they need to reduce their price so that when those factors are added in, under a total cost perspective, they will remain competitive.
• Seek a price reduction from the Supplier every time they do anything that drives up your costs, inventory levels etc.