Tuesday, February 15, 2011

Negotiation - Thoughts on Negotiating Epidemic Defects

The concept of epidemic defects is that below a certain threshold, the Supplier’s costs of any defects are limited to their warranty replacement, but once that threshold has been exceeded, the Supplier will assume a share (if not all) of Buyer’s costs associated with the defective products. Buyer’s costs can include the cost of re-work of the product and the cost of replacing failed products that failed in the field so the cost of a defect is substantial and could easily run into hundreds of dollars for a single failure.

In negotiating epidemic defect provisions, aside from getting the Supplier to agree to the concept itself, there five issues that are typically negotiated.
1.     The first rate(s) which sets the threshold.
2.     The basis for measurement.
3.     The period of coverage for the protection.
4.     The extent of the costs that will be reimbursed.
5.     Any cap or limitation on the total liability.

Since many of the costs involved in an epidemic defect would be considered to be incidental in nature, a normal limitation of liability provision might limit the damages to only those costs that are direct.  That would substantially limit the amount of the recovery. If you have a limitation of liability provision, check whether the Epidemic Defects provision is excluded from the limitation or liability, If it doesn’t include it as an exclusion.

Since the potential cost of an epidemic defect is substantial, Suppliers first seek to avoid the risk by pushing for a high failure threshold. In negotiating the threshold one of the things to use is the Supplier’s quality and reliability commitments or specifications. For example, if a Supplier is committed to shipping a product with a quality rate of 50 parts per million (PPM), and wanted a epidemic defect rate of 2 %, you would highlight the fact that a epidemic defect rate of 2% is really 20,000PPM, and when you compare that to the committed quality level of 50 it doesn’t make sense, as what they propose is 400 times above the quality level they agreed to ship. If the quality numbers are real, the threshold for an epidemic defect situation should be much lower.

Another thing that typically gets negotiated is how the rate is established. What makes up the numerator and denominator to establish the percentage? Suppliers will traditionally want to limit the coverage to only the warranty period.  This causes a problem if there is a significant difference between the warranty period and the agreed reliability commitments for the product (usually expressed in terms of MTBF mean time between failures or FITs (power on hours at a certain environment). If you have a product with a 2 year warranty and it’s supposed to last 100,000 hours (about 12 years), if you don’t have epidemic defects coverage and there are significant failures after the 2 years has passed, you wouldn’t be able to recover anything as your warranty would have expired. Always look at the elements of the formula used to establish the rate. For example if you did agree to limit the period of coverage to the warranty period you would want the formula to be based upon defects occurring during the warranty period divided
by the number of products under warranty. Suppliers frequently have the tendency of wanting to have the numerator be tied to a shorted period where the denominator is tied to a longer period or higher amount so while the percentage may be the same the actual number of units required to trigger the epidemic defect is more.
For the costs that will be reimburse, many epidemic defect provisions allow for the collection of all actual and reasonable costs that are incurred. This is to prevent the language from being interpreted as a penalty that would not be enforceable. A common supplier tactic in negotiating costs is to try to require that they be “out of pocket” costs.
The use of “out of pocket” would exclude the Supplier from having to reimburse the Buyer for any internal costs it may incur.  For example if the Buyer used its own service personnel to repair or replace defective items at a customer site, “out of pocket” would prevent the Buyer from collecting for all those expenses.

Limits on the amount that the Supplier may be liable for can be expressed in a number of ways:
·       A per unit limit
·       A per incident limit
·       A per term limit
·       A per life of the agreement limit
·       A combination of multiple such as per unit limit, with a aggregate total amount of liability over the term of the agreement.
What’s best and what a good limit would be is really dependent upon the circumstances. For example the impact of a defective item is far less if the customer can simply return the items, than it would be if the Buyer need to dispatch service personnel to the field to remove and replace the defective item.

My personal opinion on the amount is it needs to be reasonable enough so it isn’t burdening your purchase price but it needs to be big enough so it has the Suppliers attention so the Supplier will make investments to correct problems that have or can cause defects. If all they have is warranty redemption obligations that may not be big enough for them to make the necessary investments. 

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