Friday, January 21, 2011

Requirements Contracts

In a requirements contract the Buyer promises that they will purchase all or a defined percentage of its goods or services exclusively from the Supplier.  An output contract is an agreement where the Buyer agrees to purchase all or a fixed percentage of goods or services the Supplier is able to produce.

Creating a requirements contract is like entering into a marriage with no possibility of a quick or inexpensive divorce, so the negotiator needs to be extremely cautious about entering into any form of requirements contract. If it makes sense to have a requirements contract,  the agreement needs to have its own form of pre-nuptial terms that identifies what’s required for the commitment to remain in effect and what exceptions may occur.

Prior to agreeing to a requirements contract you would want the assurance that the Supplier will remain competitive over the entire term of the commitment. Competitiveness means not just the price of the product or service you are purchasing, but the technology of the product being competitive in the market. Competitiveness also applies to the terms they agree upon and the Supplier’s performance for quality, delivery and the overall cost of doing business with the Supplier. That’s because not all cost involved in the relationship is included in the price.

If the commitment is for a product or service that is under development, the commitment needs to address how delays in the schedule impact the commitment. I don’t know of any companies that will make commitment to purchase without being assured that the completed accepted product or service will be available for delivery when they need it, not months or years later.

Any commitment needs to address the impact if the Supplier fails to meet the Buyers demand. For example what happens if the Supplier refuses to accept orders? What happens if the Supplier doesn’t have the available capacity to meet the Buyer’s demand? What if the Supplier is unable to perform due to a force majeure situation?  If the impact is for a short term it may be acceptable, but for any longer period it means lost of sales and profits, loss of market share and potentially loss of customer base or it means not being able to use the product or service that you purchased for internal use to meet a need or solve a problem..

Even if the Supplier would allow you to purchase from an alternative source,  you also need to be concerned about what commitments or investments were needed to create the alternative and what you would need to purchase to get the appropriate return on the investment. Even with commitment of percentages of business you also need to protect against periods where the Supplier is unable to perform and how that can impact the other Supplier or Suppliers. I’ve always been of the opinion that for commitments of firm quantities or percentages, every order that is placed on the Supplier that they can’t meet should count toward meeting the commitment. Otherwise you’ll have a situation where to meet the committed percentage for the period you would have to penalize the Suppliers that were performing by cutting their volumes to make up the quantity needed to meet the percentage.

Any requirements commitment should address other activities that could have a negative impact on the relationship such as a bankruptcy, or possible merger or acquisition with a competitor, or the sale of the business providing the Product or Service, and what impact that has on the commitment.

As you would be locked into that Supplier, the contract needs to be thoroughly reviewed to determine what terms and remedies need to be changed so they are consistent with a requirements contract. For example, if your standard remedies for late delivery were:
  1. The ability to cancel the impacted order.
  2. The ability to require shipment by premium freight and
  3. All remedies available at law of in equity
Canceling the order does you no good as you are obligated to buy from them. Premium freight may not be enough to expedite delivery. Lastly, your primary right for the breach of a delivery clause is to cover and seek additional procurement costs as damages, but you are prevented from buying from another, so without changing the remedies you would get no product or service, but could only collect money damages which isn’t adequate. What you should want as a remedy for non-performance is for the requirements commitment to end.

Reviewing Supplier Proposals

In reviewing the Supplier’s proposals in preparing for the negotiation there are a number of steps you should take. The actions you take may be different depending upon the procurement policies you must follow.  For example, in public procurement if you discovered a mistake in a Supplier’s bid the only option you may offer them is to either stand by their bid or withdraw the bid. In private settings you may have broader options, especially if the Suppliers know that the proposal is not intended to be final and that additional negotiation can be expected. The key is treating all Suppliers fairly. So in the example of a mistake in bid, you might allow the Supplier to correct the mistake and at the same time ask the other suppliers whether they want to update their proposal.

In reviewing their proposal:

1.  Make sure all questions are answered.  If they weren’t go back to get them answered or find out why they did not answer them.

2. Check to see if all items requested were in fact provided and provided in the format requested. For example, if you requested a breakdown of the price, did they provide it?

3. Check the bid or proposal for errors in math. Check all extensions of pricing at the volumes quoted and all additions to make sure there has been no mistake.

4. Document any bid exceptions taken.

5. Document any contract exceptions taken.

6. Document any assumptions included.

7. Document any other requirements or other issues include in their proposal

8. If the Supplier is potentially under consideration for the negotiation, review the exceptions, assumptions and other requirements or issues with them to fully understand what they have proposed and why. For example are they opposed to making a commitment in general, or do they object to the specific requirement. Would they agree to a slightly different requirement. 

How you do that is important. You don’t want to signal the fact that they may be the primary supplier under consideration.  Explain that you are in the process of clarifying proposals with all Suppliers.  When you do that and you review the exceptions, assumptions or issues with them, they can interpret them as needing to be favorable or they will be either disqualified or be at a disadvantage versus the competition.  Many times it can make a number of the problems simply go away especially if they want or need your business.  I’ve also been known to tell Suppliers how much of an impact certain things will have on our cost to do business with them, providing them with the underlying message that for them to win the business on those terms they will need their price to be that much lower than their competition. When you add a price tag to their issues it can help make issues go away. Sales organizations aren’t measured on the terms that get finally agreed and they have leeway to take certain risks. They may get measured based on the margins they achieve and may be more willing to give up an issue rather than be forced to reduce the price in order to remain competitive.

One of the key tactics in negotiations is to set the right expectations with the Supplier on what it is going to take to get your business. That has to occur before any bid or quote and be reaffirmed during the clarification process. If you don’t set expectations with the Sales person, they won’t have set expectations with their management on what they need to win the business. I’ve see sales people walk away from business rather than wan to go back to their management to explain that they misread the customer.

Another reason for making sure that you fully understand what the Supplier’s issues or problems are is it takes time to schedule and complete a negotiation, especially a major negotiation. The last thing you want to do is find out late in the process that there is a significant disconnect between the parties.  When that happens the alternatives are usually all bad. You can start over with another supplier and have a significant impact to your schedule, or you can be forced to accept less to not impact the schedule. Further the more they know you are locked into them, the less willing they will be to make concessions.