Using a Supplier to help you reduce cost.

In a blog someone asked me how you can get a supplier that you "beat the heck" out to drive down cost to bring creative money saving ideas to the table? My response was the two are not exclusive. The key is you need to structure the contract terms to drive the behavior that you want to see.  You can drive down the initial price and then use a form of sharing of the cost savings to provide incentive for the supplier to bring those creative money saving ideas to the table. The key is the supplier needs to get a significant percentage of what they save, otherwise they won't take the time or make the effort. It may also require changing the compensation structure of the contract.

Here's an example. Many electronics companies use Contract Manufacturers to build product and the usual formula for compensation is you have value added costs (the labor hours) direct materials cost and the two create the direct cost. The Contract Manufacturer gets compensated the direct cost plus a percentage for overhead and profit.  For example if their combined percentage for overhead and profit was 15%. For every dollar they save you they would lose 15% in the contribution to their overhead and profit. That approach is contrary to the goal of having the Supplier help reduce the cost.

If you want the Supplier to help reduce the cost, you can't penalize them for their being successful.  One approach would be to agree that if they generate any cost savings, you will make the amounts for overhead and profit a firm number instead of a percentage. That way if they help you they don’t get penalized and if they don’t they don’t get rewarded.  If you don’t change the approach all that will happen is the Supplier will want a larger percentage of the savings to offset what they will lose because of their compensation for overhead and profit will be less because of the reduced cost.

There is also nothing to prevent you from having a sliding scale of shared savings where the more they generate, the bigger the percentage they get to keep.  The key is having a structure that drives the behavior you want.  If you structure it right, for every dollar they reduce the cost, you get your share and the cost to you is coming from monies you would have paid if they didn’t show you how.

The same type of principle can be used in selling.  Companies may reward salespeople or their channels based upon the type of business they bring in. When I worked for a Bank we implemented a program where we would allow advertisements to be printed on the back of the paper used for ATM receipts.  As low volume advertising amounts would increase our cost of printing, we structured the agreement to try to drive the company selling the advertising into making larger sales by paying higher commissions on higher volume sales. While that may sound strange, we wanted those higher volume sales and that was a way to do it. If they brought in low volume sales that would cost us more, they would earn less and that would help us offset the higher printing cost.