ARTICLES | Caveat Emptor - Long-term Contracts

Caveat Emptor - Long-term Contracts

May 22 2019 By Procurement Professionals caveat emptor, CFO, contract, COO, cost breakdown, delegation, inflation, Karrass, long-term, market knowledge , price control, procurement, procurement skills, purchasing, RFx, structuring, terms and conditions , Ts&Cs

Old Clothing Merchant in Cairo (1866) Jean-Leon Gerome

Beware the buyer.  This Roman call for caution has echoed over the millennia, and is as relevant today as it was on the day it was first uttered.  It is still an integral part of our law and commerce, carrying a warning to all those entrusted with committing an organisation's money.

Somewhat more recently, but in the same vein, Karrass1 famously warned that one must never assume that you are getting the deal you deserve, and that all assumptions should be challenged.

There should be little doubt that in many situations long terms relationships with suppliers are preferred, for a variety of reasons.  Procurement organisations should be aware, however, that establishing and maintaining long-term contracts will require specific skills that should not assumed to be present where the norm has been ad hoc orders and annual contracts.  The consequences of not being able to meet these specific challenges could range from embarrassing, at best, to disastrous (for procurement at least). 

The focus here is on one critical aspect of the ongoing management of a long-term contract, namely the need to ensure that rates (or prices) remain competitive over the life of the contract.  This aspect is critical as one of the consequences of the award of a long-term contract is that the buying organisation voluntarily creates a single-source situation and so (largely) loses the benefit of competition, until the next time that the market is tested formally.

Long-term Contracts TableThe acceptable maximum period between such market tests is a moot point.  Table 1 was compiled by the United Nations as part of a "Review Of Long-Term Agreements In Procurement In The United Nations System".  It is clear that most of the UN's long term agreements do not exceed five or six years, but a period of ten years was recorded.  The UN, as an intergovernmental organization, would be managing its affairs as a public sector entity.  It is probably safe to assume that long-term relationships, and longer term relationships, are much more common in the private sector.  (see, for example Spend Matters®: Public versus Private Sector Procurement - Why Private Is Better (Maybe ...)  One reason for this would be that the rules of responsible procurement are, or are assumed to be, more internalised in the private sector and processes are often less rigorously policed than in the public sector, where written policies and procedures, and audits, are common.  Contractual relationships, whether recorded or not, lasting ten years or longer would, therefore, be more common in the private sector.  This is, in all probability, particularly so for service contracts, requiring close working relationships between service provider and client, as well as difficult implementation processes.  But it would also be so in the case of products where not only security of supply, but also product attributes, and supplier involvement, are critical to the production process.  And it would, of course, also apply to monopoly situations or near-monopoly situations, where it is important to keep a second or third supplier in the market.

The two graphs below illustrate the effect of not being able to keep prices aligned with what would be considered the general rate of inflation among those suppliers who contended for the business at the time of the award.  For the sake of simplicity, average rates are used - in reality there may be years of "under-recovery" and years of "over-recovery", but the end-result would be the same.  Granting, on average, a 4% increase per annum, when 3% would have ensured continued competitiveness, results in prices being over-inflated by 5% and 10% after five and ten years, respectively.

Long-term Contracts GraphsBut would granting 4% when 3% should have sufficed (an excess of 33%), not be an unlikely error to be made by a procurement practitioner?  Not so.  When the country's inflation rate is in the order of 6% per annum and the buyer is unaware of the fact that supply and demand forces in the relevant market have kept its inflation to 3%, the supplier's request for a 4% adjustment would sound "very reasonable".  A request for a 7% adjustment, with a convincing motivation as to why a one percentage point increase over the national consumer (or production-) price index is justified, will also not find too much resistance from the buyer unaware of the real state of affairs.  The result, over time, would be a grossly inflated cost to the procuring company.

So, what is the moral of the story?

The lesson is that procurement practitioners should not be lulled into complacency by the excellent, efficient, and friendly service provided by the supplier, important as those performance-related aspects are.  Caveat emptor!  The reality is that the harsh commercial environment punishes any neglect in procurement, whatever the cause.  Long-term contracts are not established so that procurement can sit back and accept that the matter is taken care for a number of years. Being in control of changing rates on a long-term contract is, in some ways, more onerous than using the market every year to verify rates.  But this should not be the reason to avoid long-term contracts - the benefits outweigh this difficulty.

In order to know whether a request for an increase (and by implication the adjusted rates) is reasonable, the procurement practitioner has to either have comprehensive knowledge of the market or comprehensive knowledge of the costs of the supplier.

Generally a proper picture of the market is only obtained through inviting submissions by suppliers, which will include rates, and the terms and conditions applicable thereto, as part of an RFx process.   Gaining proper market knowledge during the term of contract, in order to compare rates, is problematic.  It should not be necessary to explain why "testing the market" by creating the impression that business may be awarded, is not an acceptable practice.  Any attempt to gain proper knowledge with full disclosure that it is to be used for "internal rate comparison purposes" only, will not provide a credible check, should it solicit a reaction from significant role players at all.  Published rates may sometimes provide an indication of trends or rates, but would simply also not be sufficient for the purpose.

The only viable option is for the procurement practitioner to have a comprehensive knowledge of the service provider's cost structure.  The best time to obtain this information is at the time of a sourcing event, before a contract is awarded.  The greater the strategic importance of the subject matter, the greater the onus is on procurement to take the steps necessary to obtain all the relevant information, including a detailed cost breakdown, details of cost driver indicators with good accessibility, as well base dates and figures.  This may, however, be easier said than done.  In certain industries, or in certain regions perhaps, it may simply not be the type of questioning tolerated by large, powerful service providers.  Should the information not be forthcoming, the buyer should, in theory, consider the next best offer, but if that means giving away a substantial discount for starters, it may very well not be in the buyer's best interest and it would also be problematic to get internal support for the approach.  The only alternative then is to gather this information over time by insisting with every increase request for full substantiation - this approach ìs likely to get internal support.  However, provision for questioning applied-for rates should be part of the RFx documentation, by implication making it part of the service provider's offer and the contract.  Provision should also be made that the rates shall remain unchanged in the absence of agreement on new rates.  Not only will this approach ensure that increases are at least challenged, but information on the service provider's costing model will be built up over time.  AB

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1) Dr. Chester L Karrass, author, commenting primarily on matters related to negotiation and procurement

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