Friday, January 14, 2011

Section Headings

In most contracts the drafter will include section headings to make it easier to find specific sections in the agreement.  One of the things to determine is whether those section headings can be used to interpret the terms of the contract.  Without a term that addresses how they will be used, language in a heading may add additional terms or requirements. A common term that is used for that clarification would be something like
“Headings.  Headings to any section or subsection of this agreement are for reference only and shall not be used to interpret or construe the meaning of the specific section or any other provision of this Agreement.

If you have an Agreement that does not contain this type of language you need to make sure that the language in the heading isn’t creating an unwanted term. For example,  I’ve seen agreements that had the warranty section entitled “Ongoing Warranties” and then within the text of the section it says that the “Supplier makes the following on-going warranties”, where the Supplier struck the on-going language in the text but not in the heading.  If there was a headings provision the impact of that would be that warranties would not be classified as ongoing warranties. Without the headings provision even though the language may have been struck in the body of the section, it would still be considered on-going warranties.

Another example is where the heading for the contract term contains the statement that “Time and rated of delivery is of the Essence” or “Time is of the Essence” and then in the body of the section there is also a statement about time being of the essence” the same would occur.  If you struck it in the body and left in it the heading, without a “headings” section the time of the essence commitment would still remain. With a headings section it would be eliminated.

Best practice is to first look to see if there is a “headings” section. If there isn’t one make sure you closely review and manage what’s included in the heading language just to make sure the other party isn’t trying to slide something by you by including language in the heading rather that the body of the clause.

Self Inflicted Wounds

Frequently the greatest obstacle to getting the best cost and terms is not the supplier, but the actions that occur within the Buyer’s company itself which impact the ability of the procurement organization to be successful. It’s one thing when you lose the battle because the supplier had the power or leverage to win against you. It’s a totally different thing when the source of the Supplier’s power or leverage comes from actions taken within your own company by your fellow employees or managers. Instead of shooting yourself in the foot, someone else is pulling the trigger.  To successfully manage cost requires that the process from end to end be managed in a manner where competition and leverage is maintained until the final supplier agreement is reached.

There are many ways to lose power or leverage. Sometimes it is done in-advertently by those who may not even think about it. Other times it may be done knowing that potential problems could occur, but it is outweighed by other factors they feel are more important at the time.
Suppliers have an arsenal of weapons they use in this battle. On the frontline they have technical sales personnel focused on helping designers with the goal of becoming designed in. Some of their weapons are the ability to provide design services to reduce development cost or design time, or the willingness to fund their own development activities to get a lock on the business. Other weapons are far more subtle, such as tracking the degree or acceptance of their products or how they stand against others so they will understand what, if any, real competition exists.

Most companies do a poor job of managing the process end to end process and maintaining competition and leverage. Many times they know that their costs are too high, but they are unwilling to attack the systemic problems that cause it.

As product life cycles have become shorter over time, the ability to correct the problem later such as during production is substantially diminished. Design resources that would be required to qualify an alternative probably have moved on to another development project, and the savings a new sourcing activity could provide is reduced due to the reduced life cycle. Those reduced savings always needs to be compared against the lost opportunity of using those same resources in development. What this means is that unless something is done to systemically change it, the problem will continue. 

Half the battle is education and it’s important that everyone involved in the process understand the impact of their actions. You won’t get the best cost / best deal if:
w  Activities commence and the procurement activity is an afterthought.
w  You invest substantial money in one supplier before concluding negotiations as that makes        
      changing suppliers more costly than any price differential.
w  You allow time to trap you into one supplier, where a change in suppliers would significantly
      impact your desired schedule, time to market, or time leaves you with no other choice.
w   The Supplier knows  they are the only one who can meet your schedule.
w  The Supplier knows that you need them more than they need you.
w  You lack the discipline which drives standardization.
w  You fail to re-use designs and materials.
w  You don’t have the operational discipline to drive usage through contracted suppliers.
w  You allow Groups to optimize their individual activity at the expense of the whole.
w  Every person on the team doesn’t stress the need for it to be competitive.
w  You’re internally restricted on what you can pursue.
w  You buy custom when standard will do.
w  You aren’t prepared when you negotiate.
w  You don’t ask for it.

While it’s nice to place the blame on others for the problem, many times the Procurement function may clearly be an accomplice or may even be driving the actions that are against their own interests.  Here’s an example: I was helping negotiate the renewal of an agreement with a Supplier and was having little success on getting the Supplier to agree upon a number of key terms that would have represented increased potential liability for the Supplier. I believed that I had leverage as there was potential new business that could be impacted. Part way into the negotiation I discovered that the manager of the Group I was negotiating it for was off negotiating a separate “partnership agreement” with the same Supplier where in return for a reduced price and extended payment terms the Supplier would get an increased percentage of the Business. Those “partnership” discussions totally undermined the negotiation I was having. The Supplier was clearly getting a message that all they needed to do to get more business was to lower their price and give longer payment terms. They simply had no fear of losing the business.  The correct way of doing it would have been to have coming to agreement on terms be a pre-condition of any additional commitment. I couldn’t believe that someone in Procurement was so dumb that they didn’t understand the impact of their actions.

Service and Support Related Issues

In most purchases you make, one of the key things to address is how you will meet the needs for on-going service and support. The approach you take and the specific requirements will be dependent upon a number of factors:
§  Will the service and support be provided by you, the supplier, or a third party?
§  Is the item you purchased repairable?
§  How long will you need the support?
§  What commitments are practical / economically feasible from the Supplier?

If you were purchasing a piece of capital equipment, the on-going service and support negotiation would probably focus on a maintenance or service contract in which you would describe what is included, what the cost would be for things that aren’t included and what the frequencies of normal maintenance would be and what the response time and escalation process would be in the event there was a problem.

If you intended to do self-maintenance on the equipment, the focus of your negotiation would be on being able to purchase all the needed items you need to allow you to perform self-maintenance. This could include training (both initial and remedial), field replaceable units (FRU’s), spare parts, repairs, plus any special tools, software or equipment needed to perform the maintenance.

If you were purchasing an option or assembly, in which you didn’t feel you could perform any repairs, the focus of your negotiation would be on being able to purchase replacement units and repairs.

If you were purchasing an item that you had the capability to perform the repair, you would also want to be able to purchase any necessary spare parts, especially any proprietary components.

If you were purchasing components used in a product, you would want to focus the negotiation on be able to purchase the product as long as you need it for both production and long term service needs, or until you can implement an alternative strategy to assure you continuity of supply.

If you were purchasing a true commodity type product where you can easily buy replacement product from multiple sources or have repairs performed by multiple third parties, your need is not as critical, but you should still try to negotiate commitments at the time of purchase.

There are 2 keys in all these negotiations. The first is you need firm commitments on pricing for as long as you need to buy the product or service. Without a firm commitment on pricing, the Supplier can effectively negate all the other commitments they may make by simply pricing it in a manner where it is cost prohibitive to purchase.  A firm commitment doesn’t mean that the pricing has to be fixed for the entire term, it could me that pricing is established by a pre-agreed formula so the Supplier can’t unilaterally raise the price making it cost prohibitive. The other key is to have the commitments be made as part of the initial purchase where you have the most leverage and can get the best deal. This is part of managing the negotiation from a life cycle cost perspective. If you wait until after you are locked into the Supplier you will always pay a premium substantial premium.

In negotiating the cost of individual items like FRU’s and spare parts versus the entire product, you can probably expect that the sum of the parts will usually be more than the price to the entire product. When I worked with a service group our goal was to not pay any more than 30% more than what we expected the manufacturing cost to be for the item with overhead and profit included. This is because there is usually a real cost difference in selling an item as a FRU or spare part where the item needs to be tested and packaged individually and inventoried awaiting demand.

Like anything else, the area of cost that you need to be most concerned with is for items where there will be an expected higher demand. Suppliers will know the expected items that will fail and could easily set low prices on items that aren’t expected to fail and higher prices on those that are in an attempt to have their pricing seem reasonable.

 In negotiating support services the keys are always to define the scope of the services (what’s included and what’s not), the frequency of the normal or preventative maintenance services, and the response times and escalation processes in the event of a problem.

In most service or maintenance these days the service technician’s role is limited. Few if any repairs are actually done at a customer’s site. The technician’s job is to as quickly as possible identify the source of the problem and then swap out what they believe may be the problem with known good replacements. The term “Field Replaceable Unit” is the way this is done, where the technician will swap out “field replaceable units” with known good ones and then the FRU is returned to a repair depot or the Supplier where it can be tested to determine if it is defective and then be repaired in that setting if repair is necessary and if the repair is economically feasible. This approach reduces the service technician’s time at the customer site, but also can create a significant amount of good product being returned because it may be simply faster to replace multiple items than determine the exact cause of the problem. When the Buyer does no screening of these returns, the Supplier will be paying for the cost of testing of products that may not be defective and may push to negotiate no-problem-found or no-defect-found charge to either cover these increased costs or have the Buyer do the screening. My argument on NDF charges is that as soon as the Supplier agrees to pay my costs when they ship me bad product, I’ll be glad to pay them for when I return good product. 

If the Buyer will do any of the repairs, the commitment from the Supplier must include the ability of the Buyer or a 3rd Party to be able to purchase any proprietary parts needed to do repairs or perform service. If you don’t have this, the Supplier may not sell them to you and the Supplier than makes them may be prohibited from selling them to you.

In all situations what you need to include will be affected based on whether the product itself is repairable (many may not be) and whether repair is economically feasible, and many low cost items may not be economically feasible to repair which then increases your need to have a commitment that they will sell you the product for an extended period.

One of the biggest challenges in negotiating long-term support is the fact that the Buyer may not have the leverage with the Supplier or Supplier may not have the leverage with other suppliers that will allow them to continue to purchase the lower level parts of the product. For example, chip suppliers who buy their chip fabrication from a 3rd party fab will be affected when that fab does an end of life of the fab or process used, as that will no longer allow the chip to be manufactured. Component manufacturers will design new components to be more competitive in the marketplace and will routinely end of life products that are replaced by their newer products. They will also end of life products that simply are no longer economically feasible to build, or which have limited demand. In most instances the Buyer may not have the power to force them to continue production and even it they did, production for only the Buyer’s volumes may not be economically feasible. Even if the supplier provided all the needed commitments of long term support, if you don’t have the cost locked in the Supplier could effectively negate the commitment by simply making the cost to buy the product or service be prohibitive.

When companies want to end of life their support of a product they sell, it’s usually done in two stages. The first stage will be to price the support in a way that discourages the continued use. Then they will come out with a end of life statement that they will no longer support the product after a certain date. They may do this to drive a migration to other products to get new sales and lower their service cost, or they may do it because they can no longer buy what is needed to provide the support and have probably already started to do cannibalization of products to provide the needed support parts.

To deal with the fact that the Buyer may not have the leverage to get competitive cost long term support, the next best approach is to require that the Supplier provide end of life notices combined with the option to make last time buys. In taking this approach there are two things that Buyer’s need to manage. First, the length of notice has to be sufficient enough to allow the Buyer to:
1.     Determine whether any Supplier alternatives or replacement products may work in their application.
2.     If there are no alternatives or replacement products that will work, they need time to establish a strategy to deal with the need to re-design or convert to another product and be able to buy product to support all needs in the interim.
3.     If they can’t convert, or conversion doesn’t make economic sense, they need time to determine what the expected requirements will be for any remaining production and service needs.
The second thing that needs to be addressed in such a negotiation is the quantity the Buyer can purchase. This needs to be sufficient enough to allow the Buyer to:
  1. Cover all needs until there can be a transition or
  2. If a transition isn’t possible, cover the estimated production needs until it will be phased out and also cover and service related volumes for the estimated life of the product.

End of life commitments may be structured in a variety of different ways but in most cases the key in the negotiation comes down to several points. Any inventory that the Buyer wants the supplier to build, the Supplier will want to be firm and un-cancelable. Any inventory held by the Supplier will usually have a limited period of time during which the Buyer must consume it or buy it. The negotiable points may be the level at which the product is held. For example, if a chip process was going end of life, the parties could agree to produce a “die bank” of wafers to be held in inventory that are manufactured under the process, but not have the product be completed. You could do that since the final process steps such as bond assembly and test activity would not be impacted by the wafer fabrication process change. So the inventory could be held at the die level rather than the finished chip. That reduces the risk and possible cost if the Buyer guesses too high on the inventory level, as rather than have to pay the full product cost,
you would want to pay the only to the level completed.

In Service and Support negotiations the speed in the repair or replacement of the product has an impact on the inventory levels of product that need to be held. Since inventory is costly, may have a shelf life and could wind up being obsolete, Buyer’s may push for creative approaches to reduce their inventory levels. For example, rather than return an item for repair and have to wait the time it takes for the item to be repaired before getting it back which forces you to carry more inventory, you could negotiate a form of “advanced swap” program where the Buyer notifies the Supplier that they will be returning a product, and the Supplier sends the replacement product out immediately. If the Buyer doesn’t return the product, they are charged the cost of the product, but it they do, the Supplier repairs the returned product and puts it back in inventory for the next advanced swap.

In negotiating any out of warranty repairs as part of service and support, that repair should also have a warranty, and that repair warranty period should be consistent with the work performed and the repair supply chain. One important decision is whether the repair will replace only the item that failed or will also replace other items that may also be likely to fail. If all you do is replace the item that failed, there may be a number of other items that could be close to failure, so the longer the repair warranty the higher the risk to the supplier.  

The last thing to consider in negotiating repair warranties is how long, if any, the repaired item can be expected to sit in your inventory. If you will use the item immediately the repair warranty period should as a minimum be long enough to ensure that it will be used under the expected conditions to ensure that it is working properly. If you carry inventories of replacement parts, in negotiating the repair warranty period you need to take into account how long the repaired item will be held in inventory. You don’t want your repair warranty to lapse while it sits in inventory. There are several ways to manage this. One way is to negotiate an extended warranty term on the repair taking into account how long you will hold it in inventory. Another way is to have the warranty commence not when the Supplier repaired it, but when you put it into service.