Sunday, December 19, 2010

Third Party Beneficiary

Under contract law concept of privity only the parties to a contract can sue to enforce the contract. An exception to that is called a third party beneficiary.  A third party beneficiary is someone who has the right to sue on a contract, even though they are not a party to the contract where they would have privity.  In most commercial agreements a third party beneficiary is created by the parties to the agreement agreeing that another party is an intended beneficiary to the contract and they agree to give that third party the right to enforce the contract.

A Buyer who is a Third Party Beneficiary to a contract between their Supplier and a Subcontractor would be able to enforce that Supplier/Subcontractor contract against either the Supplier or the Subcontractor.  The reason why a Buyer would want those rights can be two fold.  If the Buyer needs the Subcontractor to perform, they could proceed directly against the Subcontractor especially if the Supplier was not taking the actions needed.  The Buyer could also proceed against the Supplier to make sure that the Supplier meets their obligations under the contract so there is performance by the subcontractor or to force the Supplier to enforce their rights against the Subcontractor. 
This would apply irrespective of the commodity you are purchasing whether it’s for goods, services or licensing software.

Why do you need to be a Third Party Beneficiary?

When you are dealing with and relying upon other parties, you don’t control all the circumstances around that relationship. There can easily be circumstances or facts in their relationship that could impact one or both of them performing or it could impact the one of the parties being willing to pursuing actions against the other party to ensure their obligations are met. Being a third party beneficiary takes those influences out of the equation and provides the Buyer the rights to enforce the performance they were promised or relied upon.

To be a Third Party Beneficiary, you would normally place an obligation on the Supplier to make you a third party beneficiary. For example:

Supplier agrees that it shall make Buyer a Third Party beneficiary for the contract between Supplier and ______ and such agreement and shall provide Buyer the right to enforce the terms of that agreement on such purchases on a joint and several basis.

Third Party Purchases

When a Buyer wants a third party to make purchases directly from the Supplier, the third party would traditionally not have privity of contract with the Supplier unless the Buyer’s contract provides for it. If those third party purchases are not made under the Buyer’s contract, the Buyer would have no privity of contract with the Supplier for those purchases and any terms and conditions that exist between the Buyer and Supplier may not be enforced.

When you deal with third parties there are three basic approaches:
  1. You can have the third party be fully responsible.
  2. You can have the Supplier agree to extend the Buyer’s terms to the third party.
  3. You can have the Supplier agree that Buyer may enforce the terms of its agreement directly with the Supplier even though the Third Party is making the purchases

Making the Third Party Responsible
To do this your agreement with the third party would need to have equal or better terms than what you have with the Supplier or you are losing protection. The third parties would need to negotiate their own terms with the Supplier. Common issues with this approach are:
1.     The Supplier may not be willing to offer the Third Party the same terms.
2.     The third party may not have leverage to deal with them as the Buyer is directing them to use that Supplier. 
3.     If there is a cap on liability in the agreement with the third party, problems with that Supplier will count against what the Third Party is liable for.
4.     The third party may also be concerned that if there is a problem with the Supplier, they (the 3rd Party) will be liable to IBM and would have to get recovery from the Supplier adding to their risk.
5.     The Buyer has no privity of contract with the Supplier for those purchases and Buyer’s sole recourse would be against the Third Party.

Extend the terms to the Third Party
To do this you would need specific agreement from the Supplier that the Third Party can make purchases at the same terms as the Buyer. To ensure that you don’t lose any of the contract protections that you have with the Supplier either the agreement with the Third Party needs to have equal or better terms than the agreement with the Supplier or you also need the Supplier to agree that the Buyer will be a third party beneficiary under that agreement so the Buyer may enforce those terms directly against the Supplier on those purchases. The advantages of this approach are: You can place full responsibility with the Third Party; you have the right to go against either the Third Party or the Supplier. The disadvantages of this approach are: Many Suppliers may be unwilling to provide third parties with the same terms they provide to the Buyer; the Third Party may do significant other business with the Supplier and would want those terms to be extended to all their business which would add additional risk or loss of profit on those other relationships with the Supplier. Further if the Buyer had preferential terms with the Supplier, in disclosing the Supplier’s terms, the Buyer runs the risk of losing any competitive advantage it has in those terms.

Agree that Buyer may enforce the terms of its agreement directly.
To do this Buyer’s agreement with the Supplier would need to agree that the Buyer might enforce the terms of its agreement with the Supplier even though the Third Party would be purchasing them on behalf of or for use with Buyer that effectively creates a form of third party beneficiary. The advantages of this approach are: It allows the Buyer and Suppliers to mask the terms from the Third Party; the Supplier’s sales model with the Third Party for other business is not impacted; the Buyer keeps the competitive advantages it has and it facilitates Supplier’s being willing to provide the Buyer with the best terms. The disadvantages of this approach are: you don’t have a single point of responsibility and would need to determine whether the Third Party or the Supplier are responsible; Suppliers may be concerned with potentially being liable to both parties or may want the specific clause that may be only enforced by the Buyer.

One further set of caveats. When you authorize a third party to make purchases its important to disclaim any liability for their actions or inaction. Those relationships need to be separate independent agreements between the Supplier and the Third Party.  I would also require that purchases made under those terms be exclusively used for the Buyer.  A Supplier may provide certain volume allocations knowing that the products will be for the Buyer and you don’t want the third party using those allocations to potentially support other customers.


In negotiating contracts, in addition to the basic performance schedule and milestones which may be agreed upon, there are a number of other time frames included in a contract that must be agreed upon. For example:
  • Lead time for placement of orders.
  • Period for confirming orders or return of acknowledgment copy of the P.O.
  • Purchase period for the agreement.
  • Period prior to end of purchase period during which orders can be placed for delivery after the close of the agreement.
  • Notice period for an extension of the contract.
  • Extension periods.
  • Number of days before scheduled delivery when early delivery penalties apply.
  • Number of days after scheduled delivery when late delivery penalties apply.
  • Notice period required to reschedule individual orders.
  • Notice period required to cancel individual orders.
  • Notice period required to cancel the agreement.
  • Number of days late before you may cancel orders without liability.                               
  • Cure periods for breaches.
  • Inspection periods allowed prior to commencement of warranty.
  • Warranty periods.
  • Notice periods required prior to conducting audits and source inspection.
  • The Payment period.
  • Period for suppliers to pay on Buyers' debit memos.
  • Period for response, escalation of problems.
  • Period for warranty repair or replacement.
  • Warranty period for repairs.
  • Notice period for proposed product changes, end of life activity.             
  • Review and approval periods.
  • Spare parts and repair availability period.
  • Spare parts lead-time.
  • Period confidentiality information must be maintained as confidential.
  • What is the cure period for breaches?
  • What period of notice is required for termination for convenience?
  • What is the maximum acceptable force majeure period?

While many of these may seem relatively insignificant, each time period that you negotiate can impact your direct or indirect costs and some can drive investments in inventory. For example:
·       Longer lead-times may mean carrying a larger internal inventory to provide flexibility.
·       A longer period for spare parts or repairs usually means having to stock more spare parts inventory or it can mean a longer period that the item is unusable.
·       A longer period for responding to problems frequently means more problems and more cost.
·       Longer periods to cure breaches can mean the expense of dealing with a problem supplier will just last longer.

Prior to agreeing upon any time period, consider the impact that period would have.  I can remember a situation where a Buyer negotiated a price reduction. Rather than have it be implemented immediately they agreed to have it take effect on the beginning of the next calendar quarter. Based on the reduction and volume of purchases being made that one time frame, which may have seemed insignificant to the Buyer, cost almost $200,000. The time didn’t seem significant, the amount of the reduction wasn’t great, but when you calculated the impact of the volume of purchases during that period the cost was significant.

Consider advantages or cost to them of any alternatives. If it provides them with an advantage, use that to get concessions in other areas.

When creating a time period always be very clear what you intend. For example if you establish a term expressed in days, does if mean calendar days or business days? The difference in time may be significant. For business days, are they your business days or the Supplier’s?

Total Cost - Quality From A Cost Perspective

What costs are driven by quality and reliability? The answer clearly depends upon both the magnitude of the problem and the point in the process at which the defect is discovered. Some years ago, the President of Ricoh™ described the cost of a single quality problem. It was something that clearly caught my attention. In that he said that for a single problem the costs were:
In design
Before buying.
Before manufacture.
Before the product is shipped
At the customer’s location

As time has passed and business models have changed, the cost of Quality is probably even greater and while companies are able to reduce their cost of the supply chain, they still have difficulties in managing the cost of quality. With the advent of Supplier managed quality and the elimination of most incoming inspection by Buyers, the impact of a quality problem is even greater as the quality problem with the product will frequently not be identified until it becomes production level fall-out that would require either re-work, or possibly scrapping the product if the cost of the re-work is prohibitive. 

The cost of quality consists of the following elements:
  • The increased cost for material, as a result of an increased safety stock necessary as a result of quality problems.
  • The increased cost of inspection at incoming inspection.
  • The cost of handling a failure, when the failure occurs at incoming (including administrative costs to return).
  • The cost of handling a failure, when the failure occurs in process (including administrative costs to return).
  • The cost of field defects.

Reliability costs include costs associated with reliability problems which occur in the field such as spare parts and repairs inventories, cost of service calls, cost of replacement, processing returns of failed material, etc. The cost of reliability problems is difficult to compute for several reasons. First, most reliability failures occur in the field and you must rely upon the quality of the failure data that is received from the field. Second, because of the relative low cost of some items, it may be more economical to throw away the failed material rather than send it back through a repair loop. The elimination of the repair loop eliminates failure analysis. Third, there will be failures that occur without your knowledge, as not all material will come back through your channels for repair. There are two types of basic reliability failure costs. First, are the infant mortality costs which occur either in incoming inspection, or testing of a higher level system. The second type is when the statistical average of failures which occur in the field fail to meet or exceed the agreed to mean time between failures (MTBF) of the item. Infant mortality failures are reliability failures that usually occur in the manufacturing or test process. The cost of such failures is the same as an in process failure.

The cost of a failure in the field is the most expensive of the quality/reliability cost factors. The cost includes:
  • The base cost of a service call.
  • The installation cost (After the technician arrives, how long does it take to have the part removed, the new part replaced and any testing performed).
  • The administrative cost to return the item for repairs. This includes the cost of verifying the failure, issuing orders, packaging etc.
  • Throw away cost for items that aren’t repairable.
  • The cost of repair of the failed item. Repair costs if the items that failed are usually only covered by a warranty of a duration that is far less than the agreed to MTBF.
  • The cost of repair or re-work cost for the product the failed item was assembled on.
  • The increased spare parts stock. Spare parts stocking levels are initially set based on projected failure rates but will be adjusted periodically to reflect the actual failure rates.
  • The down time and losses that are encountered by the end user.
  • The effect on service revenue profitability (since a large part of the basis of establishing the service charges is the projected reliability).
  • The effect on future sales, since sales in many cases are based on total cost of ownership or amount of "up" time.
  • Less the value of any recoveries provided by warranties or epidemic defects type provisions.
When you look at all these different costs, it’s easy to see how the President of Ricoh identified the cost of a defect in the field as being multiple hundreds of dollars.

The simple fact is that standard warranty provisions only cover the repair, replacement, refund or credit for the specific part. Warranties do not cover any of the other costs associated with the defect such as:
1.     The service call to identify the defect and remove the problem item from the customer site and replace it with a working field replaceable unit (FRU).
2.     The cost to return the failed product to a repair center.
3.     The cost to “re-work” the product to remove the failed part and replace it with a new one, or the cost to scrap items that are not repairable.
4.     The cost to manage warranty replacement of the failed part.
5.     The associate cost of inventories of FRU’s required because of the expected failure rates.   
If all the Supplier pays is for the cost to replace the failed part itself, the Buyer is assuming all those other costs for a problem over which they have no control.  Here’s an example. Assume a printed circuit card that the Buyer uses de-laminates after the Buyer has placed all the components on the card. Some of those components cannot be removed from the card without being damaged, so the de-lamination would cause the scrapping of components, plus all the costs associated with removing the other components and placement of them and the new components on a new card. The cost of the card itself may be minimal in comparison to the cost of the components that were damaged and had to be scrapped, or the cost of the rework. Providing you with a new printed circuit card does not make you whole for all those other costs.

As the costs of a field failure can be staggering, any time there is a problem you can expect that even if you have all the right protection built into your contracts, the Supplier will look for every way possible to avoid that liability. It is at that point when the specifications become extremely important. To avoid the cost Suppliers will look for some factor to avoid liability. Did the product’s use meet the specified parameters? Was the problem caused by the way it was handled or assembled? Was the problem caused by causes beyond their control such as electro-static discharge? Did the Buyer provide any portion of the design that could have caused the problem? Were the damages caused by improper use of the product?

Most contracts include “limitation of liability” provisions that prevent the Buyer from recovering anything other that direct damages, and the impact of this is most of the costs a Buyer encounters with a defect in the field are incidental or consequential damages, and as such would be excluded from any potential recovery unless the commitment to pay those associated costs is excluded from the limitation of liability.

When you don’t have the incidental costs associated with a warranty failure, your cost of warranty calculation becomes slightly easier. The calculation is what is the expected number of failures that will occur in the period and what is the cost of the failure (which may be the cost of the replacement or an out of warranty repair cost). The expected number of failures time the cost per failure divided by the projected volume would be the additional cost added because of the difference in warranties. The expected number of failures can usually be calculated based on the stated reliability of the product. So if a product had a Mean Time Between Failures reliability of 100,000 hours, that 100,000 is the average and statistically there should be a certain percentage of failures that should occur in each year, the average of which creates the mean. Normally the failure rates will be high in the first year (attributed to what they call infant mortality problems) and be low, rising up over time as the product begins to reach its useful life. If you can statistically predict the failures that should occur in those periods and know what your cost of an individual failure is, you should know the potential total warranty cost difference which you would then spread over the estimated purchases to determine the unit price impact on a total cost basis