Monday, April 4, 2011

Cost In Terms, Cost in Performance

Procurement agreements are all about who bears what costs and risks. The Supplier’s behavior and performance can drive both your cost and your risks. Cost issues exist in most terms. In every Procurement Contract there are terms that will impact cost directly, indirectly, or by the risks (which if they materialize) will create a cost. Something as simple as a delivery term can have a huge impact on cost. If the Supplier sells a product on Ex-Works or FOB Origin terms, the Buyer must pay for:
·       The freight between the Supplier’s dock and the main shipping carrier.
·       The cost of clearing a product through export customs,
·       The cost of the international shipment of the product
·       The cost of clearing the product through import customs
·       The cost of any duties involved with the import.
·       The cost of the carrier to the final delivery point
·       The cost of insurance, or in lieu of insurance the cost associated with the risk of loss if the product is lost or damaged in transit.
·       If there is no insurance and the product is lost or damaged, the Buyer would need to pay for the cost to replace the item as they assumed the risk of loss. 
·       The delivery term may also establish when payments must be made, which is a cash flow cost.

In addition to actual cash outlays, cost also exists in the contract terms in four key areas:
o   Cost of money. (Cash flow dealing with payments).
o   Cost of Inventory
o   Inventory levels required by lead-times,
o   Inventory caused by restrictions on rescheduling and cancellation.
o   Inventory required for minimum buy quantities,
o   Inventory required because of Supplier deliver performance.
o   Cost of Quality (Dealing with Supplier quality performance)
o   The degree and value of the remedies the party provides if the fail t perform.

All payments in the contract involve the cost of money. Changes may involve a cost difference in the change but will usually also involve the cost of obsolescence, scrap, and new value added costs to implement the change (production, set-up, tear-down). Rescheduling or cancellations usually involves costs of cancellations, costs of restocking, administrative costs, sales or re-brokering commissions, changes in the value of materials, all which is a cost, etc.

The warranty term and any limitations may impact the life cycle cost of using the product. Warranty returns will involve the cost of managing the return, the freight cost to and from the Supplier, the cost of repair (if not covered) and a loss of value in the term in which you were not able to use the product. Frequent warranty returns may also create the cost of needing to establish and maintain a spare parts inventory. Contract termination for either cause or convenience deals with the cost of any damages sustained, the cost impact to inventory, work in process, the cost of alternative sourcing, and the cost of production downtime. Etc.
Limitations of liability are cost limitations. They deal with the potential cost exposure for damages sustained, whether the costs are limited only to direct damages or may include other costs such as consequential or special damages or other costs and they may include specific financial limitation on the amounts to be paid. Limitations of liability may limit a Supplier’s exposure, but many times the Buyer’s real financial losses can be far in excess of any limitation.  Insurance and indemnity provisions deal with the issue of who will bear the risk and cost associated mostly with third party claims. If the Supplier doesn’t protect you, your company may wind up bearing the risk and the associated cost.

A Supplier’s performance and what your rights are relating to that performance will have an impact on a number of other potential costs. For example, if there are quality problems with the Supplier’s performance you have both the direct cost of that quality problem and the indirect cost of that quality problem like having to purchase and inventory additional product to cover the fall-out. If the Supplier is inconsistent in delivery you also have the cost of having to adjust your inventory levels to deal with that inconsistency in a way it doesn’t impact you.

To understand the relationship between terms and cost, you need to understand the concept of Total Cost. Total Cost requires that for each item you assign a cost value (positive or negative) depending upon the terms you negotiate or the actual performance you have. If you use it properly it can help in decision-making processes between competing Suppliers or, in negotiating the best deal possible with the selected Supplier.

Here are a number of standard terms found in many contracts. Generally the Buyer’s goal is: to lower cost; lower risk; and make the Supplier responsible. The Supplier’s goal is generally to avoid assuming costs or risks and make the Buyer responsible as much as possible and still make the sale. Who wins this battle will be determined by the terms you negotiate.

Delivery term
Distribution costs,
Duties, other potential charges
Supplier: transfer costs at their dock.
Buyer: Have Supplier bear the cost at no charge or less than your cost.
Delivery risk of loss
Insurance costs, or loss exposure
Supplier: Transfer risk at their dock.
Buyer: Have Supplier bear risk
Payment period
Cash outlay,
Time value of money
Supplier: Receive payment ASAP.
Buyer: Delay payment to delay cash outlay and carrying costs.
Late payment charges
Cash outlay,
Time value of money
Supplier: Have customer cover carrying cost if late in payment.
Buyer: Avoid late payment charges to allow further extension of payments.
Price adjustment periods
Price risk with movement in
the market.

Supplier: Seek frequent adjustment periods to avoid potential cost exposure.
Buyer: Dependent upon the market assessment (if price is firming or upward risk seek longer term, if loosening or decreasing seek shorter.
Engineering Changes
Purchase Price Variance
Process costs,
New VA costs (production,
Set-up, tear-down)
Supplier: pass on all associated costs and improve margin when possible.
Buyer: Protect against unreasonable charges, nibble for some to be overlooked.
One time NRE charges
Cash outlay,
Time value of money
Supplier: Seek advance or payments concurrent with costs
Buyer: Seek extended payment terms as long as charge or rate is lower than your value of money.
Materials pull in (requests
Shorter than lead time)
PPV for expedited materials,
labor costs for overtime etc.
Supplier: Seek more than costs based on customer value of opportunity.
Buyer: Pay only those reasonable costs required.
Lead times and standard
PPV for expedited materials,
labor costs for overtime etc.
Supplier: Offer only what can be done without risk or premium.
Buyer: Seek lowest possible lead time without burdening product cost to reduce level of inventory maintained
Customer reschedules or
Cash outlay,
inventory costs,
Supplier: Charge them for any costs and affect it has on production schedule or make it more advantageous for them take it rather than cancel
Buyer: Allow only charges for
activities during WIP and non-cancelable, non-returnable parts and pay nothing for standard parts they can use elsewhere.
Excess/ Obsolete material
disposition process and
Costs of cancellations,
administrative costs,
sales or re-brokering commissions,
Reduced value of materials etc.
Supplier: Make them responsible and then charge them costs for added services
Buyer: Assume responsibility for only unique, non-cancelable parts.

Maximum inventory

Cash outlay,
inventory costs,
time value of money
Supplier: Manage maximum and charge a carrying cost if they exceed the maximum.
Buyer: Avoid any charges, if necessary pay carrying costs only for unique materials that help you get shorter lead times.
Warranty scope
Warranty costs
(returns, repairs, test, package etc.)
Supplier: Limit warranty to minimum which will still be competitive
Buyer: Seek extended term for all aspects. Use reliability to help get extended term.
Warranty returns
Distribution costs
Supplier: Seek their payment both ways or share costs.
Buyer: Seek Supplier payment both ways.  “We paid for quality which we didn’t get”
Termination for cause
Dollar Damages Liability,
Inventory Obsolescence,
Production downtime costs
Supplier: Seek to avoid or limit to only major recurring problems.
Buyer: Include to cover the potential costs and damages if re-Procurement is necessary. Also look for other commitments if performance problems are recurring.
Termination for convenience

Inventory obsolescence,
Production downtime
Customer responsibility for costs.
Supplier: Make it painful and expensive to prevent movement to other Suppliers.
Buyer: Seek ability to walk away at any time with only materials liability if it is in Buyer’s best interest.
Confidential information
Dollar damages liability for potential
unauthorized disclosures
Supplier: Seek to have everything identified, limit time, limit information you receive.
Buyer: Same, protect our information.
Limitation of liability
Limit on direct damages for all
potential causes unless otherwise
Supplier: Seek maximum dollar limit to limit exposure and make it only direct damages.
Buyer: Avoid limits to insure recovery of at least all direct damages and seek consequential damages for certain problems.
Insurance, Indemnity
For Injury
Cost of insurance (claims affect rates)
Supplier: Limit only to our negligence.
Buyer: Seek broad coverage including j
Cost of licensing technology, cost of replacement with non-infringing and cost or field recalls
Supplier: Limit exposure to refund the purchase price paid or cost of license if reasonable.
Buyer: Require Supplier to correct the problem and cover all costs

Many of the costs may be indirect. An example of an indirect cost is quality level performance. Based on a committed quality level you would stock one level of inventory. If the actual performance is below that committed level, it requires you to purchase more and carry more inventories. The cost of that inventory, the cost of you managing all that defective material for return to the Supplier is an indirect cost. Another example of indirect costs is any supplier term that forces you to take delivery of a product before you need it such as terms which have deliveries be non-cancelable or non-reschedulable orders, or limitations on the number of times you can re-schedule or limitations like only being able to reschedule within a specific quarter. 

Risks also represent cost in terms and an example of a risk is a third party claim of any kind. The third part claim could generate the cost to manage or defend against the claim, and it could include the costs or damages needed to settle the claim or a court awarded that. If the Supplier does not protect you against third party claims that are attributable to them or their Product, that becomes a risk to you and a potential cost. If they limit the extent of their responsibility, any excess exposure becomes a risk to you and a potential cost.

Performance related costs should tie closely to the remedies. For example, if the Supplier fails to ship on time what are your costs? There could be excess costs of re-procurement, expedited freight, and handling, it could also cause other types of incidental or consequential costs. If your only remedy is to cancel the order, do you have adequate coverage for the risk?

You may never be able to have the Supplier cover all your risks and costs, as that may be cost prohibitive, so what you do want is for their commitments to be competitive. One way to make the risk less prohibitive is an allocation or sharing of risk or responsibility. For example, many what’s called an epidemic defects provision usually represents a sharing of the risks and cost. For example, most are written where for something to become an epidemic defect, there is a threshold that must be exceeded. Another threshold may be defining what qualifies as a defect, such as the defects must be of the same root cause. When you consider this the sharing is that 1) the Buyer is assuming the costs until such time as the threshold is met before the Supplier starts being responsible. It also means that the Buyer is assuming the cost of all the other defects that aren’t of the same root cause until such time as they have also exceeded the threshold. If you were to allow the Supplier to also cap their liability, you have a sharing of the risk, as any losses above that cap would be your responsibility.  

To be good at negotiating procurement contracts you need to understand two things about cost:
1.     What makes up the cost of the product or service?
2.     What drives costs in total life cycle of the product or service?

Cost is based on the simple formula of rate times the demand. To negotiate cost you need to know how to negotiate the rate, based on what should or shouldn’t be included in the cost formula, but you also need to know how to negotiate things that will drive unwanted demand as demand drives cost. For example, if there is a problem with a Supplier’s quality, those quality problems drive a demand for added costs such as increased inventory costs, expedited freight and processing costs, increased inspection, re-work costs, etc. If you can get high quality, you eliminate the demand for those activities that eliminates those incremental costs as you have eliminated the factors that were driving the demand.

There also are a number of factors in every contract where the degree of the Supplier’s commitments will either add to or reduce your costs. Every exclusion or limitation usually takes cost and risk (that may become a cost) away from the Supplier and leaves it with the Buyer or leaves the Buyer to assume any cost above what the Supplier has agreed to provide.

If you think of cost under the formula of rate times the demand, to reduce your costs you have two choices. You need to either reduce the rate, or you need to reduce the demand. Your goal in negotiating contracts is to manage those things that are driving demand as those are also driving added costs. Your contract terms are the things that determine who bears the cost. They also determine who bears the risk that can become a cost. They further determine what costs the Supplier can push on you. Here’s a simple example. The Supplier takes the position that they will allow you to reschedule purchase orders, but not past the end of a quarter. This then forces you to take all deliveries before the end of the quarter whether you need the product or not. What’s the impact to you? The language is creating unneeded demand that’s creating demand for cash, a demand for inventory costs and potential risks such as the risk of loss or obsolescence. Demand drives cost. If you weren’t forced to buy the product you could avoid all that demand which would avoid all those resulting costs. Many times in negotiating rescheduling provisions what you find is that the primary reason for the Suppliers position is because the person on the other side of the table is a sales person and they simply want to make the sale in that quarter. The real impact to the Supplier of a reschedule of an order could be minimal, especially if you are buying a standard product that could be sold to other customers to mitigate the impact to the Supplier, but the impact of forcing you to take product you don’t need can be substantial. Here’s something else to consider. When you are forced to buy and inventory something your costs will be based on the completed product cost plus overhead and profit. If they can adjust their production so all the additional value isn’t added, the cost of inventory on that is far less isn’t it? If you have a cooperative relationship shouldn’t it be held where it costs less? Whenever there are things or positions that will add to your costs you need to make sure that the Supplier understands that to remain competitive there may also need to be a reduction in their price to compete with Suppliers that aren’t driving the same demand that increases your cost.

Cost of Money Versus The Value of Money

Cost of money is what it cost the company to borrow they money. A company’s cost of money will be dependent upon the prevailing interest rates at the time and will be impacted by the company’s financial position. The weaker the financial position of the company, the more risk to the lender, so the higher the rate of interest that would be charged. 

The Value of Money is the rate of return a company could make on an investment.  Most Companies will also have what they call a “hurdle rate”. A Hurdle Rate is nothing more than the minimal rate of return they want to make on an investment before they make that investment. Hurdle rates take into account the fact that companies have limited money available for investments and may have limits on what they can borrow. So one way of prioritizing amongst the investments is whether an individual investment meets their hurdle rate. Hurdle rates are always higher than the cost of money as you would need to cover either the cost or value of the money that’s used to make the investment and you need to provide a return on that investment. 

Between the Buyer and Supplier there may frequently be differences between what those rates are. For example a very large buyer with great financials may have a substantially lower cost or value of money than a small Supplier with weaker financials. There may also be substantial differences in hurdle rates to make investments. Companies that have major spending needs for acquisitions, research and new product developments with new technologies frequently have high hurdle rates whereas companies in very stable industries will have traditionally lower rates.

What does all of this have to do with negotiations? The differences in rates can present opportunities in the negotiation. The simplest example of this is Suppliers with a high cost of money may be willing to offer discounts for shorter payment payments. The differences in rates can also help decide which company should be the banker in the relationship. For example, if a company offers to amortize some or all of the development cost in to the cost of a product or service, there’s usually a cost to do that.
The cost they propose will be based upon their value of money or hurdle rate. Your decision on whether to accept it will depend upon your value of money or hurdle rate. Large companies may have their Treasury department provide periodic advise on when to accept early payment discounts based upon changes to their value of money and hurdle rate. The same thing would apply to all other investment decisions in the relationship. For example who should hold Inventory. Ideally if inventory needs to be held the party with the lower value of money and lower hurdle rate should hold it. If you try to have a Supplier that has a high value of money and high hurdle rate into doing stocking for you, what you are really doing is asking them to make an investment in holding that inventory. If you have substantial leverage you may be able to force them to do it, but you can expect that the price you pay will include their cost at their value of money or their hurdle rate to do it.  What you pay may also be more than if you made the investment.