Friday, February 25, 2011

Managing Supplier Performance

While it would be nice to nice to transfer all risks and costs to the Supplier, even it the Supplier would be willing to accept the risks, the potential cost to do that could be prohibitive. There will always be costs and risks that the Buyer needs to accept and manage. The contract is where you provide some of the tools to manage those costs and risks. There are seven ways to manage a supplier’s performance. Every contract should have five ways of managing performance: Structure, Control,  Financial, Structure to Drive Performance and Express Conditions for the Performance.

The first is what I would call Relationship management where you build a strong relationship with the Supplier’s account team so that they know and understand what you need, want and what will impact them getting future business awards if they don’t perform.  This does not need to be addressed in the contract.

The second method to manage the Supplier’s performance is Structural.  In the contract you would include all the structural tools you need to manage their performance. The larger or more complex the purchase, the more you need the structural tools as part of the contract requirements that the Supplier must meet.

Examples of structural tools that would be used to manage performance are:
  • Having clear specifications or a statement of work that makes it clear what they must deliver.
  • Establishment of a team to manage performance and Supplier contacts.
  • Identify tasks required.
  • Establish schedule, milestones and deliverables
  • Have a clear process by which the work will be tested and accepted
  • Establish a strong program review process
    • Establish meeting review schedule, frequency, attendees.
    • Implement action item lists
    • Identify content and frequency or required reposts
  • Have rights to audit any on-site work being performed for quality and performance,
  • Establish Senior Management involvement and reviews
  • Establish formal escalation process
  • Include ability to back charge management costs for significant problems, delays or resources provided.

The third method is Control.  If you have agreed to assume a cost or risk, you simply can’t let the Supplier do its own thing, so your contract terms need to provide you with the necessary control over what the Supplier can do over the things that can impact your cost or risk. Control is a way of managing behavior or performance. Examples of control type of provisions would include:
  • Control over the Supplier’s team that performs the work and any changes to that team.
  • Control over where the work is performed
  • Control over subcontracting of the work
  • Restrictions against assignment of the work
  • Control over changes to the product or service
  • Control over changes to the process.

For example, lets assume that the Supplier will only agree to sell to you on Ex-works delivery terms.  What this means is that from a cost and risk perspective you are responsible to pay for all the costs to get it from the Supplier’s dock to your point of use. If further means that you would also be responsible for any loss of damage that occurs while it is in transit. So to manage this potential risk you require that they comply with packing and packaging specification you provide that are designed to reduce the amount of damage that may occur in transit. You could also specify that you must either select or approve the carrier and lane used, as the potential for loss or damage may vary by carrier and by shipping lane. You could also require the Supplier to ship it with pre-paid insurance that would be reimbursed as a separate line item.  If you didn’t have the controls they could take whatever actions were the cheapest for them which could increase your potential risk of loss or damage.

If you can’t transfer the cost or risk of problems that the Supplier has control over back to the Supplier, then to manage the risk you should require strict control about what the Supplier can or can’t do with all the various factors that may impact risk. For example if the supplier was unwilling to assume the major risks and costs of quality problems they could create, you would require approval of subcontractors, material suppliers, restrict any assignment, not allow them to make any changes to the product or service without your advance approval, etc.

The old axiom is that anything that is not managed will cost more and if the Supplier isn’t going to bear the cost or risk of an item, in most cases they won’t make the investment to manage those risks for you unless you force them to by the contract terms or specifications.

The fourth aspect of managing performance is Financial.  The four main financial ways that manage performance are:
1.     The remedies that you have in the event of a breach of the agreement (the types and amount of damages you may recover).
2.     The costs of any remedies the Supplier is required to provide for failing to meet the specific obligation.
3.     Any pre-agreed impacts to price for non-performance such as liquidated damages or price adjustments for being late with deliveries.
4.     Impact to their payments and cash flow. For example, a term that would allow the Buyer to not make progress or interim payments if the work was behind schedule would be designed have the cash flow impact to try to drive the Supplier take necessary actions to get back on schedule.

As I say elsewhere, correcting problems is an investment decision on the part of the Supplier. If the financial approaches that are included in your contract won’t have a significant financial impact on the Supplier, the Supplier probably won’t make the investment to correct the problem.

The fifth aspect of managing performance is structure terms to drive the desired performance.  A classic example of this is many times a Buyer will want the Supplier to help you reduce the cost of the work. Which approach will work better in meeting that goal?
  1. Fixing their overhead and profit amount and sharing in the savings, or
  2. Paying them a fixed percentage for both overhead and profit based on the cost of the work?   
To me the answer is clear.  "A" provides the Supplier with an incentive to perform, whereas "B" provides a negative incentive. How much help would you expect to get if helping you penalizes them by reducing the amount the Supplier gets paid for their overhead and profit?

The sixth aspect of managing performance is making sure that you include and negotiate express conditions for that performance.
  1. Make it an express commitment in the Agreement.
  2. Use language that establishes it as a firm commitment .
  3. Avoid any softening or qualifying language that would reduce the commitment.
Any commitment that includes “efforts” as part of it, whether its Best Efforts, Reasonable Efforts or Commercially Reasonable Efforts doesn’t guarantee performance. All it does is require the Supplier to extend that level of effort in trying to perform.

A seventh and last way of managing the Supplier’s performance is Contract Administration.  The amount of contract administration you need will be dependent upon the Supplier and the risks. There are three main focus to contract administration. One is to manage the delivery of any Buyer deliverables. That is to avoid claims by the Supplier. The second is managing Supplier performance with the goal of obtaining products, supplies or services, of requisite quality, on time, and within budget.  For contract administration to be successful you need the structural management tools to be in place.  The last focus on contract administration is maintaining the working contract file. A good contract file should consist of the following:
1. A record copy of the contract, highlighted to show any amendments made and when those amendment were made.
2. A record copy of the applicable statement or scope of work, annotated to show any changes agreed and the effective date of those changes.
3. Copies of all amendments
4. Copies of any change requests and their disposition.
5. An action item log.
6. Copies of all correspondence to and from the Supplier
7. Minutes from all meetings and calls with the Supplier
8. Copies of any inspection reports on the progress of the work, site visits, audits, etc.

Whether you win or lose on a claim or a law suit will be dependent upon being able to establish who did what and when and what the requirements were at a specific point in time.  Below are two examples of what I mean.

When I worked in construction I once had a claim by a site work contractor for additional costs to bring in new soil to make the necessary elevation grades that were called for by the drawings and specifications. The first thing I did was to review our on site inspector’s daily reports that included all on site activities including deliveries and things being removed from the site. There was a clear record of the Contractor being delivered all the soil that he claimed. A further review of earlier reports disclosed two things. One was the contractor had previously removed substantially more soil and that was taken off the site. The second was the architect instructed Supplier to not remove broad segments of topsoil and expose the remaining soil to the elements where if it got wet it would need to dry out before use. I was also able to see from the daily reports the weather and their progress and how the rain made some of the remaining soil unusable. Based on my findings I refused to pay any amount toward the claim based on the position that 1) there was an excess of soil on the site and had they not removed it, they would not have needed to bring in new soil. Their actions of uncovering too much soil they created the problem that required new soil.

In another situation we had a situation where a electronic circuit card that was supplied by a Contract Manufacturer had a specific component on it that was failing and costing significant field costs. The Contract Manufacturer argued that because it was a component that we had specified and they had purchased from our approved Supplier they should have no liability.  The component supplier was currently approved and the CM was authorized to purchase from them. We did research on what the dates of those purchases were that were failing. We then went back to our agreement to see at what point in time the specific part number was added to our agreement. What we found was that these purchases were made by the Contract Manufacturer before that part was ever added to our contract.  Under the terms of our contract with the Contract Manufacturer these would be considered as parts they directly sourced for which they assumed full responsibility.

The more you have changes in the personnel that will manage the contract on both sides the more important it is to document and maintain this type of information so it isn’t lost. It also doesn’t hurt to have a running summary of all the problems that the Supplier caused that cost you extra money and have that documented and available for use at the end of the work. That’s when Suppliers may come in with a claim for extra work and extra costs. It’s at that point when you would present your list of counter claims and use it to reduce or offset their claims and recover any excess costs.