Posts Tagged ‘3PL Contracts’

For the last 15 years the Third Party Logistics industry (3PL’s) have been growing at an average rate of 15% annually.  More and more companies are outsourcing pieces of their supply chains to 3PL’s.  They do this for three primary reasons:

1. The function outsourced is not the company’s core competency
2. Outsourcing provides speed and flexibility
3. To save money

Often, the structure of the agreement between the customer and their 3PL partner is cost plus.  This can come in a number of tailored formats but for the most part, the 3PL is paid their cost plus a management fee.  While fees vary based on the service provided, costs are suppose to be what the 3PL paid.  Here is where many companies overpay.  For most, this overpayment could be avoided by asking a few questions upfront and checking the bills a little closer  throughout the life of the contract.

As stated earlier, cost plus contracts are set up to charge the customer for actual costs paid for goods and services plus a fee, which is ideally the profit for the 3PL.  There are four areas that companies should consider, both when negotiating the agreement with the 3PL and when paying the 3PL’s invoices.

The first area to focus on is benefits.  Unless specified in the contract, benefits charged on wages should be the actual cost of the benefits.  That means that rebates that the 3PL  gets on health insurance and workers comp should be credited to the customer.  If you are charged a “standard percentage” and you don’t ever get a rebate, but the language in the contract says nothing other than cost plus, you are being over charged.

If, however, the contract stipulates that there is to be a standard percentage applied to wages for these categories, then the charge would simply be the percentage applied to actual wages.  Remember, in many operations hourly wages can be as much as 40% to 55% of total operations costs.  If you are charged a couple of extra points over cost of benefits, that could be a lot of money during the life of the contract.

The next area to consider is temporary labor charges.  Many temp agencies offer rebates to 3PL’s based on volume over  the quarter or year.  As the customer, you have the right to see the agreements and call the temp agency to discuss the specific arrangements.  If there is a rebate from a temp agency, or from any supplier for that matter, in a cost plus arrangement, you have the right to your share of the rebate.

Many operators also provide systems and systems support.  While support typically is based on a percentage of software license cost, the actual systems license costs are much less direct, and in reality are in large part profit.  You will hear arguments that the license costs have to cover a lot of R&D, overhead, and other indirect costs you, the customer will never see.  Truth is it is profit.  You should not pay management fee on this. This is one of those areas that should be addressed up front.  If it isn’t spelled out or included as a line item on a budget, you should not be charged a management fee.

The last point to look into is corporate allocation or charges for overhead.  Like some of the topics above, unless this amount is clearly defined as a percentage of total costs or something similar, it should be the actual costs.  The big mistake that many make, however, is that they pay a management fee on top of a corporate allocation / overhead.  In effect, you are compounding the fee paid to your provider.

Most experienced supply chain executives throw out charges associated with corporate allocation / overhead right from the start.  You should have one fee to negotiate.  Don’t allow yourself to be put in the position of negotiating two, three or four fees depending on the activity.  This is a tactic used by some 3PL’s to simply make more profit.

There are many areas that companies must watch out for when negotiating and managing their 3PL agreements.  Hopefully you have these four critical components in control.  If you aren’t sure, at least you know where to start looking.

January and February is the time of year when companies send out RFP’s (Request For Proposal) to solution providers. Most companies come up with a long list of providers to include in the first round, with hopes of culling the list down to the top three or four for the next round. Many companies target awarding the business in the first quarter so they they can get things up and going by the end of the second quarter, which will ensure they will be fully operational in the third quarter.

There are basically two approaches companies can take in selecting a third party to provide supply chain management functions. The first approach is the “Commodity Pricing” approach. This is used by companies that, for a number of reasons, are going to base everything solely on price. The lowest, BELIEVABLE price will get the deal.

Most of the Commodity Pricing RFP questions concern establishing credibility and presents in the market. Of course, the final version will be based on exacting specifications that require a firm price. Often the final RFP will have a completed contract that has to have pricing filled in and signed when returned for final review and selection by the buying company.

Companies that issue Commodity Pricing RFP’s don’t care how much is profit, what the provider’s cost is, or what assumptions were built in by the service provider. Their only concern is their cost. For some it could be a cost per unit, others look at total dollars out of pocket, and some ask for a monthly dollar amount for fixed expenses and a firm cost per unit based on volume.

This approach works great if the solution calls for a “commodity service” that is not customized, such as moving full trailers from one location to another. However, if customization is called for or if there is going to be significant variability based on uncontrollable conditions, the Commodity Priced approach can end in disaster for both the company and the provider.

The second approach to developing supply chain RFP’s is what we will call the “Relationship” approach. If you are going to outsource a supply chain function that requires flexibility on the part of the provider and the rate of variability is high, you want to select a provider that you trust, one that will work with you and is willing to agree to contract language that will ensure the providers interest are in alignment with your interests.

Relationship contracts are often volume based. Many times contacts are cost plus with a budget cap, based on a mutually agreed to set of assumptions. These contracts are much more complicated than a fixed priced agreement but they can result in much better service over the long haul. Watch out, though, contacts with assumptions and variability require a lot of effort and oversight to ensure everything is on the up and up. If you are outsourcing a function to an industry expert, you better have an internal expert working for you otherwise you could be taken to the cleaners.

VP’s of Procurement often hate “Relationship” RFP’s and the resulting contracts because they are “fuzzy” and require a significant amount of subject matter expertise.   Procurement folks also don’t like the RFP’s for “Relationship” providers because they usually have to ask a lot of questions about culture, customer experience, references, intellectual capacity, questions that get to the depth and breadth of the 3PL but don’t say much about how much it will cost.

Selecting a provider with the idea of building the proverbial Win / Win relationship usually comes down to the two senior guys getting along. The senior decision maker basically hires the senior solution provider based on trust that is developed during the vetting process.

So, if your company is going to outsource this year and you are putting together an RFP, you need to carefully think about what kind of service are you outsourcing. You should begin with the end in mind and ask yourself the following questions:

1. What type of RFP and contract is typical for the industry?
2. How much variability occurs that is out of our control? How predictable are the basic metrics?
3. How complex is the supply chain function that you are outsourcing?
4. Why are you outsourcing this function?  Flexibility? Lack of knowledge internally?  Tight resources?
5. What kind of additional “value adds” are you looking for the service provider to bring?
6. How long do you anticipate the contract and associated relationship to last?
7. What was the justification used to get approval for the project?
8. What risks can be controlled if included in the contact?  Shrinkage, mis-ships, worker’s comp, health insurance increases, union organizing efforts……

This short list of questions should help get the gray matter working.  The one important component in developing an RFP and later, a contract is to ensure that you have someone on your side of the table that is as knowledgeable as the supply chain solution provider sitting on the other side of the table.  If you are equally matched and you end up with a professional service provider that hits it out of the park, you will come to see outsourcing as a career building step second to none.

But remember, it all starts with the RFP.

If you are negotiating a cost plus or variable rate contract with a 3PL or similar outsourcing company, there are a few often overlooked areas you should focus on to ensure you get the best negotiated rate possible. 3PL contracts are complicated but there are certain contract topics that are used to “hide” profits for the 3PL. If left unchallenged, this will provide a cushion or extra profit that your company will pay for.

Most people new to negotiating outsourcing agreements are really good at focusing on the management fee and over head numbers. A savvy 3PL company will recognize this and will bury profits elsewhere. They aren’t duplicitous, they are simply building in negotiating tools that can be used later.

The first place to look is if they have an “Overhead” or “Corporate Expense” category. When you question this, you may hear something like, “this is to cover the additional overhead required by your operation.” Think about that. Question them on exactly how much incremental costs they will incur and what is that money spent on. It’s not unusual for a 3PL to throw this category out entirely when challenged. Like everything else in contract negotiations, if they can’t explain it, they don’t get it.

Another area to focus on is on the “burden rate” or the amount charged for benefits on payroll. Again, are you seeing an estimate for actual costs or just a percentage applied to payroll? If it is a percentage, you can expect a couple of percent profit buried in there someplace. If you are seeing line items, verify the percentages and ensure you have a complete understanding of the health insurance calculation, in particular.

Next, look at how the issue of inventory shrinkage is dealt with. Ask some basic questions such as:

• Who is responsible for the cost of conducting inventory
• Is the cost of conducting inventory factored into the pricing and contract
• At what level of shrinkage is the 3PL financially responsible
• How is inventory shrinkage calculated
• Is shrinkage based on company books or the 3PL’s books
• How often is inventory conducted and how long does the 3PL have to reconcile the amount

Typically, 3PL’s are responsible to pay for all shrinkage, dollar for dollar, over the shrink provision.  Another standard area of agreement is that all inventory overages benefit the customer and are carried over to offset future shortages. Shortages over the shrink provision amount, however, are paid by the 3PL prior to the end of the contract year.

If you are negotiating a variable 3PL contract, there are a number of critical components to address.  The devil is in the details.  You need to make sure that all terms are in alignment with your internal goals and expectations.  The biggest sin anyone who outsources can make is to sign an agreement that rewards the 3PL for doing a bad job. Do your homework, know what you are talking about and negotiate hard. Win/Win is important but you don’t trust the 3PL to ensure you get your side of the Win/Win. That is your job.