Got You Covered! The 21st Century Approach To Customer/Supplier Agreements

Author(s):

Patrick S. Woods, C.P.M., A.P.P., CPIM
Patrick S. Woods, C.P.M., A.P.P., CPIM, Commodity Manager Emerson Electric/Fisher Controls, Sherman, TX 75091, 972-491-1394

84th Annual International Conference Proceedings - 1999 

Overview. Are you maximizing your relationship with your supplier? Many customer/supplier interactions are either in the North Pole or the South Pole of the relationship spectrum. Some companies have not even defined, much less, stated in writing, their expectations of their suppliers as well as themselves in this relationship. On the other hand, some companies have strangled their suppliers with legalistic, cumbersome and voluminous contracts that penalizes their every move. This presentation goes from both extremes of the spectrum to more neutral territory in focusing on developing customer/supplier agreements that provide the purchaser with necessary and desired coverage but yet, also benefits the supplier.

It has often been said in reference to any type of written agreement that it is normally designed to benefit the customer. This paper will also focus on the major areas that should make up this agreement to maximize your coverage, but in reference to the perception above, convince your supplier that they are maximizing their relationship with you. Focus areas of the agreement include term, formulas to effect price change, cost reduction goals, volume incentive rebates, technology and goals in respect to quality and delivery.

Note: The clauses explained in this paper make up what is commonly referred to as the Long Term Agreement (LTA). The LTA is different from a contract in that the LTA is a written summary of the goals to be achieved in the customer/supplier relationship. However, with a written notice (normally 30 days), either or both participant(s) can terminate this agreement. A contract implies a more "legalistic" document with termination being much more difficult and violations being subject to either litigation or arbitration. These recourses are not even addressed in the LTA. In association with the LTA, the purchase order is the contract.

Specific Clauses - Term Of The Agreement. This is a very important element in that it establishes the tone of the relationship. In the clauses listed below, it is obvious that you are expecting a great deal from your supplier. They may question, "What's In It For Me?" The term of the agreement states in writing that you are making a commitment to them for a certain period of time and at least within that period, you do not plan to resource the product and/or services covered to other supplier(s).

What should be the duration of the term? Agreements can certainly vary in term. Purchases that involve a lengthy start up or development time could be in longer duration than "on the shelf items." The agreements that I have been involved with are normally set for a term of three (3) years. In other cases, certain agreements may be "evergreen" in that they never expire unless one or both participant(s) chose to terminate the agreement.

Sample language describing the term is as follows:

Term. The term of this agreement will be for a period of__________years, commencing on _____________________(the "Effective Date"). The term of this agreement will be extended automatically, in increments of one year, unless either party gives written notice of termination no less than 30 days prior to expiration of the then-current term. For purposes of this agreement, each reference to a "year" will refer to the applicable twelve-month period(s) beginning on the Effective Date of this agreement and/or subsequent anniversaries of the Effective Date.

Specific Clauses - Price Change. One of the key benefits of this agreement to you, the customer, is a written method for handling price changes. The days of the supplier walking into your office with their standard, annual 5% price increase are over. Prior to your development of this agreement, have a discussion (perhaps negotiation) with the supplier as to what is the primary driver of price change. My experience has been that the most inflationary element of the price of a product (services may be an exception) is the raw material.

Persuade the supplier to agree that the only factor that will effect price change will be the raw material (determine ahead of time what the raw material is) and then write this into the language. Thus far, we have titled this section "Price Change" as opposed to "Price Increase." The mutual benefit of using the former title is that as raw material experiences "inflation," the supplier will justly benefit but in the event the raw material experiences "deflation," then the customer will benefit. Yes, it is possible that per this agreement, the supplier may submit a price decrease. This is definitely a paradigm change and could represent 21st century thinking.

It's not as if you don't trust each other, but how will you and/or your supplier know whether the raw material has experienced inflation or deflation as well as the amount of the change? The key is to agree to an index, which will indicate the percentage of change. Most major materials including steel, plastic, corrugated, etc. will have an appropriate index. If neither you nor your supplier is familiar with such a factor, then you may wish to consult the supplier of the raw material who would probably be familiar with such an index. As an example, Purchasing Magazine publishes its Hotline of Transaction Prices which provides the quarterly price averages for various raw materials* comparing 1996 (prior) through 1999 (future).

Steel - 10 indexes
Paper & Paperboard - 10 indexes
Nonferrous Metals - 25 indexes
Lumber - 3 indexes
Precious Metals - 5 indexes
Plywood - 5 indexes
Energy - 5 indexes
Plastics - 13 indexes
Wood Pulp - 6 indexes
Chemicals - 20 indexes

Sample language describing price change is as follows:

Price Change. The LTA will list agreed to prices for each part number covered by the agreement. Such listing will also include raw material content for each product. Such prices will be fixed for the term of this agreement, except for the following adjustments:

Raw Material Price Changes. The price for each product may be adjusted in the event of a change in raw material price OR at the end of each three month period after the Effective Date of this Agreement (each, a "Quarter"), the parties shall determine the "Quarterly Average Price" for that Quarter, which will equal the average price of___________[raw material] per_______, as published in _______________, during such Quarter. If any Quarterly Average Price is 5% greater or less than the Quarterly Average Price for the Quarter preceding the Effective Date of this Agreement, supplier will increase or decrease the price of each product containing raw material by an amount equal to (A) the difference between the two Quarterly Average Prices, multiplied by (B) the percentage of that product that is comprised of raw material. Such price increase or decrease will be effective for the next three-month period.

Specific Clauses - Cost Reduction. Supplier(s) that we want to establish relationships with are constantly striving for "continuous improvement" and are not simply resting on their laurels. One such area is cost reduction. The supplier who takes the attitude that we have drained "every drop of blood out of this turnip" does not fit the above description. One of the benefits of this agreement is that your supplier will agree to specific cost reduction goals. However, this carries a dual responsibility. We may expect our supplier to recommend opportunities to reduce cost but as the customer we have to provide the resources to receive and review the opportunities as well as to implement if feasible.

I have heard many a supplier voice a valid complaint that in the past they have suggested some very attractive cost reduction ideas but these ideas did not make it past the buyer's desk or even worse, his/her "FILE 13." To prevent this problem, as noted in the language below, it is recommended that you, the customer form a "steering committee" which is made up of 1 or 2 customer representatives as well as 1 or 2 supplier representatives (number of individuals depends on the complexity of the agreement). This committee would be responsible for meeting on a quarterly or semi-annual basis to review and/or generate cost reduction ideas.

The supplier benefits in that cost reductions in excess of the minimum percentage would be shared. Sample language describing cost reduction is as follows:

Cost Reductions.

Cost Reduction Goals. Supplier agrees to provide customer with total annual cost reductions of ____% under this agreement. Cost reductions will be measured on the total value of products purchased under the agreement on an annual basis. If supplier does not provide the agreed cost reduction percentage in a given year, supplier will rebate the amount of the shortfall to the customer within 45 days after the applicable year. The parties will share cost reductions in excess of _____% equally, as described below.

Cost Reduction Calculations. Once a cost reduction program is implemented, the measurable cost reduction percentage will be tracked by the steering committee on a quarterly or semi-annual basis. For purposes of calculating the total annual cost reductions under this agreement, a specific cost reduction program will be counted for a period of no longer than 12 consecutive months. If a cost reduction program requires a capital expenditure by one or more parties, the party or parties making that expenditure will be entitled to the entire benefit of the resulting cost reductions until its or their capital expenditures have been recouped.

Cost Reduction Implementation and Administration. The steering committee will be responsible for creating; implementing, managing and approving cost reduction programs. The customer will provide reasonable necessary support to the supplier to assist in creating cost reduction programs under this agreement. All proposed cost reduction projects will be submitted in writing to the steering committee. By __________ of each year during which the agreement is in force, beginning with the first full year covered by agreement, the steering committee will deliver the following to management:

  • A proposal, including cost reduction targets, for the up-coming 12 month period to reduce costs under its agreement; and
  • A report detailing its cost reduction efforts during the preceding 12 months, including the measurable cost reduction percentage achieved.

Specific Clauses - Volume Incentive Rebates. A further negotiation point with your supplier is a one-time rebate for business growth that your company is providing to them. This could be an area where you may have to test your Reverse Marketing skills. Reverse Marketing is the process whereby the purchaser reverses roles with the supplier and sells him or her on an idea, program, or concept that at first may be perceived as unpopular or painfully expensive. You are requesting that your supplier give money back to you.

They may ask, "How is this justified?" I will admit that of all the clauses discussed in this paper, this is probably the most difficult. How could this be a plausible point with the supplier and put money back into your own pocket? Assuming that the increased business will be absorbed by their existing capacity, then their fixed costs will have been amortized into the initial/original business volume.

In pricing the additional business volume, the only costs that should be incurred by the supplier should be direct labor and materials. Fixed costs, therefore, should be irrelevant. However, if the increased business volume requires them to purchase new equipment, expand facilities, and/or incur additional fixed costs, then the additional portion would be relevant and the expected rebate should be reduced or not pursued.

Sample language describing volume incentive rebates is as follows:

Volume Incentive Rebates. The customer will be entitled to an annual volume incentive rebate based on the total dollar amount of purchases of products covered by the agreement. Based on the annual reports to be provided to the steering committee to customer management, management will calculate the volume incentive payable on account of such Total Purchases by multiplying Total Purchases by the incentive percentage indicated on the Volume Incentive Schedule set forth below.

Volume Incentive Schedule

Total
Purchases
Rebate
Percentage*
$0.1-6.0M 0%
$6.0-6.5M 3%
$6.5-7.0M 4%
$7.0-7.5M 5%
$8.0M + 6%

* At the start of this agreement, the annualized total purchases will become the starting base, and at the end of Year 1, business growth above this starting base and within the guidelines illustrated above will be subject to the rebate. The new total purchases, which include both the initial starting base and the business growth, will become the next year's starting base and business growth above this starting base and within the guidelines illustrated above will be subject to the rebate. However, in the event that total purchases drop or experience negative growth, then the next year's starting base remains the same as the previous year's starting base as opposed to the new amount.

Example: If the initial starting base is $6M and the total purchases at the end of Year 1 are $7M, then the business growth is $1M, which includes 3% of $500K + 4% of $500K - $35,000. The starting base for Year 2 would become $7M and rebates would apply to the schedule above for growth above $7M. Assuming that at the end of Year 2, the total purchases drop to $6M, then the Year 3 base would remain at $7M and rebates at the end of Year 3 would apply to the schedule above for growth above $7M as opposed to $6M.

Specific Clauses - Quality Goals. The key to an effective customer/supplier relationship is the supplier meeting and exceeding performance expectations. An important performance expectation is quality assurance. If you already have established a system for monitoring your supplier's quality (i.e. PPM, % shipment defective, % scrap, CpK, etc.) then this can be incorporated in the agreement language. If such a system does not exist, then you may wish to develop and then incorporate into the agreement. The agreement will also establish reporting requirements regarding the fulfillment of such quality goals and will provide penalties for their failure to meet such quality goals.

Sample language describing quality goals is as follows:

Quality Standards and Goals. Supplier agrees to achieve, during the term of this agreement, a quality measure of ___ PPM. On the products supplied, Supplier will maintain a ____ CpK or better for the customer defined critical key characteristics during this agreement.

Specific Clauses - Delivery Goals. Another key performance expectation is delivery. Again, if you already have established a system for monitoring your supplier's delivery, then this can be incorporated in the agreement language. If such a system does not exist, then you may wish to develop and then incorporate into the agreement.

Sample language describing delivery goals is as follows:

Delivery. The agreement will set a time period after the issuance of a purchase order in which an order will be deemed delivered "on-time." If a delivery is not expected to be made on-time, supplier will notify the customer and will take all reasonable steps at its own cost to expedite delivery. If a delivery is not made on-time or if notice is given that a delivery is expected to be late, the customer may cancel the order immediately by delivering written notice of the cancellation to supplier. Absent such cancellation notice, supplier will deliver the order on an expedited basis at its own cost. Upon such cancellation, the customer will not have any further obligation with respect to such issue.

If a delivery is not on time and is canceled by the customer, the customer will be free to purchase the late products from a third party and deduct from payment of future invoice(s) from supplier for any difference between the third party purchase price and what the customer would have had to pay for such late products under the agreement.

Specific Clauses - Technology. Another key performance expectation is for the supplier to keep abreast and share with the customer in advancing technology.

Sample language describing technology is as follows:

Technology. As supplier is privy to new technology related to production, material and/or application, it will share this information with customer and incorporate into customer's products, per customer's product engineering approval. As requested by customer, supplier will provide prototype (timely) support to engineering cost reduction programs.

Parting Thoughts. Obviously there are additional clauses that you will want to incorporate into your LTA (i.e. warranty, indemnity, termination, force majeure, entirety, etc.) but these are primarily boilerplate and can stated both in the LTA as well as in the Terms and Conditions section of the purchase order. In determining which suppliers and commodities should be covered by an agreement, I recommend the "80/20 Rule". The 20% suppliers/commodities that comprise 80% of your supply base (exact percentages may vary but the concept is applicable) should be the first focus for agreement coverage.

Keep in mind you can put anything you so desire into an LTA but the supplier has to agree as well. Got You Covered! The 21st Century Approach To Customer/Supplier Agreements should be viewed as a positive approach by both you, the customer as well as your supplier. Good luck!

REFERENCES

Woods, Patrick S. Adding It Up: Performing Effective Supplier Price And Cost Analysis, NAPM INFOEDGE, June 1998

Purchasing, A Cahners Publication, April 9, 1998.


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