Friday, January 7, 2011

Structuring Contracts to Drive Behavior

Most Buyers aren’t interested in exercising a remedy or collecting damages, they hired the Supplier because they want the committed performance. The easiest way to drive a Supplier to behave in the manner you want is make it costly if they don’t. The terms you include in a contract will drive the Supplier’s behavior, both good or bad..

Performance problems that occur are investment decisions. Problems can usually be resolved by investments in equipment, people and resources. As an investment decision, investments to correct performance problems compete against other Supplier investments including those focused on increasing profit or sales. Suppliers won’t make investments to solve performance problems unless there is a real and significant impact to them. If being late isn’t going to cost them anything, will they make the investment to get back on schedule? If their cost from a quality problem is small in comparison to the investment they’d need to make to correct it, will they invest?

The most common terms in a contract that are designed to drive behavior are warranties. Most warranties state the behavior you want from the Supplier either at the time of execution of the contract or in the future. It is the ability to terminate the agreement  for cause and claim damages for the breach of a warranty that should drive the Supplier to behave in the manner described by the warranty.

Contract terms should be used to drive the Supplier’s behavior and many of those are driven by the remedies the Buyer will have for perfornamnce problems of the Supplier.. For example:
  • if what you want is timely delivery you can’t have terms that provide for an extended term to cure a delivery default, as all that does is give the Supplier more time to perform.
  • If you want them to consistently improve their quality, you can’t have your agreement structured where you bear all the cost and risk of them shipping you bad quality, as they’ll never improve.

The terms you include in your contract may drive the Supplier’s behavior in terms of how they deal with you versus their other customers. If the supplier has "no skin in the game” so that they will share in the pain and the cost of not performing, their natural tendency will be to always do what’s best for them, and that can negatively impact you. In times of short supply they could move more of their product through channels or to other customers where they make more than they do if they sold it to you. That's especially true if they won’t have any pain or cost of not shipping your order or not shipping it on time.

There are a number of ways to have the Supplier share in the cost and pain. They aren’t all financial, but financial ones usually get the most attention as those provide a clear ROI for the investment decision. Management reviews are an excellent way to share some of the pain, as many times the senior management of a Supplier may simply not be aware of the problem, and they can look at the solution as part of a bigger picture. Cost is clearly a way to get them to share in the pain. In identifying what is appropriate, you need to position it in the middle ground. If you make it too high that its going to significantly add to your cost or be a major deterrent to doing business with you. It must be high enough so it gets their attention and is something they need to take into consideration when making any decisions that could impact their performance on your contract.

Contract remedies are also a way to get and keep the supplier’s attention and this is where you can be more creative in terms of what you include in your contract. I prefer remedies where “the penalty fits the crime”.  Those are remedies that increase with the severity or frequency of the problem. For example, if the supplier ships a defective product, you want to be able to return it at their cost. If the supplier ships more defective products, you want to be able to reject them by lot to avoid screening them for defects. If the number of defects increases and continues over time, you may want to charge them your costs to deal with that and require faster turnaround for replacements. If it continues, you could go so far as requiring them to send their people to your location to perform repairs. If they can prove that they have solved the problem based on extended performance meeting all the requirements, you can also have those remedies be relaxed back to a lesser degree that’s consistent with their current performance.  The key is the remedy must be significant enough to get their attention and drive their behavior.

Another great remedy can be your payment terms.  For example if you were entering into a contract where the supplier was going to develop a new product for you, what payment term would give them the most incentive to be on time?  I’ve seem payment schedules that were tied solely to time and not completion of milestones that allowed a Supplier to fall behind and do nothing to make up the schedule as they know they will get paid on time. That doesn’t provide any incentive to get back on schedule. Contrast that to a term where payment is tied to completion of deliverables or milestones, where you withhold a portion or all of the payments if they fail to meet the milestone dates, but will release them when they are back on schedule.  In the later, by not paying them until they are complete, there is an incentive to complete on time. The practice of withholding a portion if they meet a milestone date should provide incentive for them to make the additional investment to get the overall program back on schedule.   

I’ve worked for companies where their standard remedy for late delivery was:  1) they could cancel the order, 2) they could require the Supplier to ship the Product by priority freight with the Supplier picking up any difference in cost, or 3) they could exercise all other remedies (which would be to sue for damages for breach of the contract).  Let’s look at each of these to see what type of behavior they would drive.

Cancel the Order. If you need the product or services and don’t have an alternative that could respond in time, this really doesn’t provide much to drive their behavior to deliver on time.

Ship the product by priority freight at their Cost. Whether this would drive the right behavior would be dependent upon the difference in the cost of regular freight versus priority and how you normally have items shipped. This probably does not represent something that is going to be significant enough to drive their behavior.

Exercise all other remedies.  In this case the exercise of other remedies would be claim damages or to terminate the agreement and claim damages. In that case, before you could terminate, you would need to allow the Supplier to cure the breach which gives them extra time to perform.  If they don’t you could claim damages, but in this case the damages for failure to deliver on time would be limited by any limitation of liability section which may limit it to only direct damages. Direct damages would be the excess cost of re-procurement. While this may provide some leverage if the difference is significant, if its not, it doesn’t provide much leverage to drive them to deliver on time.

If performance is important, you need remedies that drive the right behavior.  For example in the on time delivery situation, do you think that you would get a different behavior if you had a structure where they paid liquidated damages or the purchase price was automatically reduced depending upon the number of days late? How about a requirement that if they failed to delivery on time for a certain period, that they must provide at no cost or liability to you on site stocking of inventory at your location.   

If a Supplier is unwilling to agree a terms that helps drive their behavior I always explain why the requirement its there and ask them why they aren’t prepared to make that commitment. Sometimes they may simply not be willing to agree because they know they can’t or won’t be able to meet those requirements. You then have two choices which is to walk away from them,  or have them tell you what they are prepared to do to eliminate your concerns.

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