Tuesday, November 8, 2011

Firm Commitments

There are a number of ways you can make firm commitments. You can commit to purchase a specific amount, a specific volume, or you can make a form of requirements commitment where you agree to purchase a specific percentage, if not all of your business for a specific item to a specific supplier. If you decide that it makes business sense to make a firm commitment there are three things that always should be addressed.
1. How do you keep the supplier competitive during the term of the commitment?
2. What liability should you have if you fail to meet the firm commitment?
3. What actions or events should excuse you from purchases or reduce the quantities?.

The first issue I addressed in a Blog called Price - Getting Competitive price when locked in that’s dated September 2, 2011. That post talks about a number of tools that should be included in your agreement when you make firm commitments so the supplier either most perform or they run the risk of losing the commitment.

The amount of liability that you should have should be based upon they concept that the supplier should be made whole for the failure to meet the required commitment, but should not profit from the failure to meet the commitment. In this respect its similar to a termination without cause. The real difference between a normal termination for cause under an agreement with no commitments is because you made a firm purchase commitment to the Supplier the supplier may also have made firm purchase commitments to their subcontractors and suppliers. So instead of only being liable for unique inventory on had and on order that they can’t otherwise consume, you now are going to be looked upon to be liable for all those costs. To me the best approach is to negotiate what your maximum liability will be upfront so you establish the maximum amount you will be liable for if you fail to meet the commitment. That does two things. It creates a cap on you liability that you could potentially negotiate down from. More important, it will drive the suppliers behavior with their subcontractors and material suppliers so they don’t make commitments to them that they won’t be able to recover from you. Unless there was a major cost break on materials that was volume sensitive or the firm commitment drove the investment in equipment that would not be fully amortized by the volume you should be able to further manage you potential liability by doing things like require that the items not be built ahead, but there purchases should be based upon your forecasts and your orders,

Whenever I have agreed to make a firm commitment, I’ve also always included actions or events that count toward toward the commitment so that the size of the commitment is reduced when those actions or events occur. Those include:
For any force majeure events claimed by the Supplier I want the volumes that I would have procured from them during that period to count against the commitment. Most suppliers don’t like that, but most also have business interruption insurance that covers them against there casualty losses.
For any periods in which the supplier is selling under allocation where they cannot meet the volumes I ordered. I want all those unfulfilled amounts to count toward the commitment.
If they have delivery or quality problems where I had to make purchases from a distributor to make up for those problems, I want those to be counted towards the commitment.
For any other problems caused by the supplier that limits their ability to meet my needs, when I need them, I want all those volumes counted.
The reason why I want all those volumes committed is I made the firm commitment to purchase them for a specific time frame based upon the needs that my company had during that time frame. I don’t want to be forced to buy product after I no longer want or need it. If they couldn’t meet their commitments I also don’t want to negatively impact a supplier that stepped up to help me when they couldn’t deliver.

Let me give you a simple example. The supplier has a force majeure situation (a fire in their plant). It takes them nine months to recover to where they could produce product. The full production cycle for the supplier is 16 weeks or four months. This means that they have an excusable delay for thirteen months.

When they had the force majeure I still needed the product. I qualified another supplier, I investment in additional equipment and tooling. That supplier met my needs. Now that they have recovered if I didn’t have those volumes in the interim counting as meeting the commitment, I would still have to purchase those 13 months of volumes from them. I may not need 13 months of volumes any more. Even if I did need them volumes, if I wasn’t excused from the commitment, I would need to take that into account in the volumes I give to the supplier that came in to help me. In a worst case I would need to cliff the second supplier (reduce their volumes to zero) and lose unliquidated portions of the investments I made to bring them on. If you do that Suppliers will learn about it and the supplier you cliffed and other suppliers will be reluctant to help you in the future. If the commitment amount was reduced and you needed the product you could probably split the supply.

If you learned from this post, think about how much more you could learn from the book.
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