Friday, January 21, 2011

Requirements Contracts

In a requirements contract the Buyer promises that they will purchase all or a defined percentage of its goods or services exclusively from the Supplier.  An output contract is an agreement where the Buyer agrees to purchase all or a fixed percentage of goods or services the Supplier is able to produce.

Creating a requirements contract is like entering into a marriage with no possibility of a quick or inexpensive divorce, so the negotiator needs to be extremely cautious about entering into any form of requirements contract. If it makes sense to have a requirements contract,  the agreement needs to have its own form of pre-nuptial terms that identifies what’s required for the commitment to remain in effect and what exceptions may occur.

Prior to agreeing to a requirements contract you would want the assurance that the Supplier will remain competitive over the entire term of the commitment. Competitiveness means not just the price of the product or service you are purchasing, but the technology of the product being competitive in the market. Competitiveness also applies to the terms they agree upon and the Supplier’s performance for quality, delivery and the overall cost of doing business with the Supplier. That’s because not all cost involved in the relationship is included in the price.

If the commitment is for a product or service that is under development, the commitment needs to address how delays in the schedule impact the commitment. I don’t know of any companies that will make commitment to purchase without being assured that the completed accepted product or service will be available for delivery when they need it, not months or years later.

Any commitment needs to address the impact if the Supplier fails to meet the Buyers demand. For example what happens if the Supplier refuses to accept orders? What happens if the Supplier doesn’t have the available capacity to meet the Buyer’s demand? What if the Supplier is unable to perform due to a force majeure situation?  If the impact is for a short term it may be acceptable, but for any longer period it means lost of sales and profits, loss of market share and potentially loss of customer base or it means not being able to use the product or service that you purchased for internal use to meet a need or solve a problem..

Even if the Supplier would allow you to purchase from an alternative source,  you also need to be concerned about what commitments or investments were needed to create the alternative and what you would need to purchase to get the appropriate return on the investment. Even with commitment of percentages of business you also need to protect against periods where the Supplier is unable to perform and how that can impact the other Supplier or Suppliers. I’ve always been of the opinion that for commitments of firm quantities or percentages, every order that is placed on the Supplier that they can’t meet should count toward meeting the commitment. Otherwise you’ll have a situation where to meet the committed percentage for the period you would have to penalize the Suppliers that were performing by cutting their volumes to make up the quantity needed to meet the percentage.

Any requirements commitment should address other activities that could have a negative impact on the relationship such as a bankruptcy, or possible merger or acquisition with a competitor, or the sale of the business providing the Product or Service, and what impact that has on the commitment.

As you would be locked into that Supplier, the contract needs to be thoroughly reviewed to determine what terms and remedies need to be changed so they are consistent with a requirements contract. For example, if your standard remedies for late delivery were:
  1. The ability to cancel the impacted order.
  2. The ability to require shipment by premium freight and
  3. All remedies available at law of in equity
Canceling the order does you no good as you are obligated to buy from them. Premium freight may not be enough to expedite delivery. Lastly, your primary right for the breach of a delivery clause is to cover and seek additional procurement costs as damages, but you are prevented from buying from another, so without changing the remedies you would get no product or service, but could only collect money damages which isn’t adequate. What you should want as a remedy for non-performance is for the requirements commitment to end.

No comments:

Post a Comment