Monday, September 12, 2011

What’s the most important part of subcontracts?

Like all of these very open questions, the view will always depend upon where you sit, what you do, and who you deal with.

If you are a prime contractor that assumes risks, costs and potential liabilities from their contract with the customer, the sum of their work and that of their subcontractors must be equal the commitment to the customer. If there are shortcomings in terms of the subcontractor’s scope versus the commitment to the customer, the prime needs to cover the cost of that additional work. If there are differences between what the prime has contractually committed to the customer versus what they contractually get from their subcontractors, the prime needs to cover the cost or liability. If Prime fails to meet their obligations to the customer and is subject to damages, the prime needs to recover any damages that were attributable to the subcontractors or pay those damages themselves. For a prime contractor the most important aspect of subcontracting is making sure that all those risks are managed. Scope of each of the subcontractor’s agreements is important but it only manages one of those risks. What's important in subcontracting is making sure that you flow down the necessary requirements and liabilities that make sense for the subcontractor to provide. Understand the areas where you don't have 100% coverage. Make sure the team negotiating the prime contract is aware of the uncovered risks and uses that in negotiating both the terms and price. Then have plans is place to manage against the potential uncovered risks. Companies get in trouble when they commit to more than what they can delivery and what their subcontracts can and will reasonably assume. To a prime contractor its also important that they be assured that all needs and expectation have been flowed down to all tiers and that they can have close relationships with their subcontractors and tiers. The simple fact is that the customer isn’t going to accept failure on the part of the supply chain as an excuse. Their contract with the prime and that’s who they look to for managing it to perform. Even if there is no fault at the prime, most prime contractors will do what it takes to solve the problem from a customer satisfaction perspective. They want repeat business from the customer and they want a strong reputation in the community.

A subcontractors view will be a combination view. As it ties to their subcontractors and lower tiers they will have the same view of what’s important as the prime. Their view with respect to their agreement with the prime contractor will be different. With the prime their most important part will be that the scope of their work is extremely clear and is something they can perform. They will look at obligations and terms that the prime is trying to flow down to them to make sure that:
1) They are applicable for the work they will perform.
2) They are reasonable for the scope they will perform and represent an appropriate risk for the benefits they will receive, and
3) They are risks that they know they can manage.
If the scope isn’t clear, its something that they question whether they can perform and the obligations and terms don’t work for any of the three items, then it best for them to let the prime know so the can manage the risk of not getting those flowed down.

Five forces that shape competition.

In browsing through the Internet I came across information about competition that was written by Harvard University Professor Michael E. Porter. It was in a Harvard Business Review article. It can be found at

Dr. Porter is a leading authority on competitive strategy and has been for at least three decades. In discussing industry competition he lists five forces that shape competition within an industry.
Rivalry between existing competitors.
Threat of new entrants to the market.
Threat of substitute products or services.
Bargaining power of suppliers to the company
Bargaining power of buyers.

It’s analysis of the five forces that companies would use before making a decision to enter into a new market. This lead me to think about how those same five forces would come into play in procurement power or leverage. My thought is those same five factors come into play, but in a slightly different manners.

For example, if there is a significant rivalry between existing competitors they buyer may have enough leverage to have a reverse auction. New entrants to the market increase the market capacity so if there is no similar increase in demand, the increase in supply will add to competitive leverage for the buyer. Substitute products or services always provide additional leverage to the buyer. The supplier’s competitiveness would no longer measured against the one market, it would be measured against a broader market. With a Buyer, while the impact of the bargaining power of the supplier’s suppliers may be an issue, the thing that can have a greater impact is the bargaining power of the supplier’s other customers. An addition consideration that buyers have is the supply versus demand balance.

Conceptually the buyer has the most negotiation leverage when:
There is high rivalry in the market between existing competitors.
The market has new entrants that create new possible sources of supply.
There are substitute products or services
The barriers to switching to a substitute product or service are small.
You have a significant share of the demand for that market.
There is excess supply versus demand.

The key to leverage is if you are going to use it in negotiations you need to use it while you have it. Leverage can change, sometimes overnight. Let me give you several examples.

At a point in time the major customers for tantalum capacitors where computer manufacturers and the bigger computer company you were, the more leverage you had with those suppliers. Then cellphones were introduced, They also used tantalum capacitors, and as cell phone purchases grew enormously the total demand for tantalum capacitor created shortages. In a fairly short period the cell phone industry began purchasing more tantalum capacitors than the computer industry. Now there was competition between different industries for the supply. The potential risks and liabilities were also different between the industries. The tantalum cap manufacturers could sell to the cell phone industry at less risky terms and at the same price and that further reduced the computer industry’s leverage. The competition didn’t come from the computer market, it came from a whole new market.

All you need to do is have a disaster at a major producer of products or materials and you can have an overnight change in the supply versus demand status that impacts bargaining power. The earthquake and tsunami in Japan had that kind of repercussions on supply for suppliers located in that area. For example Toyota and Honda’s production of both new cars and parts were impacted. Their plants and plants of their suppliers were either damaged or needed to be evacuated because of the nuclear plant meltdown. Evacuations were immediate and all had to be be left behind in affected areas. Since Toyota and Honda shipments were limited other car manufacturers didn’t have the pressure of competing with them. The net result has impacted the car buyer’s leverage in their price negotiations.

If you manage a commodity for a company it’s important to keep track of not just your use, but other potential uses by other companies or industries that could impact supply in the future. If you source from high risk areas its also important that you consider investing in multiple sources. Your supply chain is only as strong as its weakest link.