The commercial agreement between the principal buyer and the service provider of outsourced logistics has far reaching, long term consequences for both parties. Cobus Rossouw of Volition shares some practical insights with Smart Procurement on how to extract the maximum value from your service provider….
“There are some common ideas being put forward as being useful in entering into outsourced logistics deals. These need to be carefully evaluated as they sound better in theory than in practice”, he says. These include:
Keeping it Simple:
- Over-simplified commercial agreements may seem easy to manage, but create significant problems along the way.
- Although it can be argued that “What we win on the straights what we loose on the corners”, the reality of cross-subsidization is that people behave to maximize their own benefit. This is not because they have malicious intent. People just behave in accordance with how they are measured.
- In many cases, actions have no commercial consequence – either not penalizing “bad” behavior, or (even worse) not providing any incentive for “good” behavior – i.e. doing this better. That leads to many improvement projects just being compromised.
Open Book Costing and Cost Plus Arrangements
- Open book costing may seem like the answer – in reality it is just to complex and actually achieves very little in the outsourced logistics environment. Even if the books are open, it does not mean that the cost drivers are understood or made transparent.
- This is part of our challenge with accountants with insufficient management accounting (or business understanding of accounts) skills.
- Open-book also creates risk around price negotiations – and most people feel exposed. I don’t believe believe that Cost+ is the correct approach in this regard.
We have to recognize that the service provider has to have an incentive to reduce cost (and not to increase it) !
Furthermore it is difficult to convince those same accountants to change the nature of a commercial agreement. They will see all the risks (that is their job) – but they are very unlikely to accept the risk that you may have to pay MORE, even if it is beneficial to the entire supply chain.
Some Practical Outsourcing Alternatives:
Against this backdrop, there are several alternatives In considering the “outsourcing decisions’. Volition has seen various initiatives where the following approaches were applied successfully:
• Separating Fixed and Variable Costs
• Reconciliation of Cost Drivers
• Formalized trade-off mechanisms
• KPIs and Gain-share agreements
Separating Fixed and Variable Costs:
“This approach is reasonably simple – and has probably been considered and/or applied by many of you. It is all about separating the fixed and variable cost elements of the agreement.
To make this work, the first important point is that the service provider must accept that his average rates will decrease with volume increases. Although this should make logical sense, most service providers do not have the required costing systems to understand this and they remain measured (by their own financial people) by an overall income average.
The second point is that volume and capacity forecasts should be shared. Again, it sounds very logical, but assumes that the different players within the different organizations actually have reached common agreement on this.
The driving principles are similar – agree on the fixed and variable and then, much more importantly, agree on how these will be adjusted as volume and capacity change over the lifetime of the contract.
It is imperative that the parties share “strategic intent” – that is about sharing where you are going and achieving mutual understanding of the limitations of marginal costing. In the long run, all costs are variable – and many service providers may compromise themselves in not providing for the variable elements,” says Rossouw
Reconciliation of Cost Drivers:
“At the outset, this may seem simple enough, yet it requires quite a brave approach.
The prerequisites are that all the cost drivers are actually understood and that a common agreement between both parties exists and, that activities can be measured.
No outsource agreement is valid unless all these elements are in place and the parties also need to agree to establish a total level of transparency.”
Formalized Trade-off Mechanisms:
“This approach may be easier to implement than the full cost driver reconciliation, and requires buying in to a mature joint decision-making process.
The usual prerequisites still remain- the need for mutual understanding and typically, the trade-off between stockholding, shipment quantities, frequencies and delivery dynamics. As with other approaches, all activities need to be measurable.”
KPI’s and Gain Share Agreements:
“What you measure, is what you get” summarizes the common approach to KPI’s and gain share agreements.
“Do not limit the KPIs to the Rand value of logistics spend only:
• How is availability measured using a mechanism that explains the underlying drivers for failure?
• Who measures inventory holdings in a way that incorporates the supply chain reality? Namely that a debit and a credit do not contra each other and that low stock of one product is not hidden by high stock of another product.
• What other KPIs should be in place, e.g. those that drive operational productivity?
While the reality of KPIs in the logistics world is that there are more exceptions than rules, this does not mean that we should not measure them. ”
Convincing the Accountants:
I would like to dwell on the last point of our positioning assumptions:
“Convincing Financial People to Change is not EASY”.
“Here are some pointers to guide us:
• In dealing with suppliers many organizations have a very aggressive approach and very little commitment, especially the financial people who generally focus on cost savings only. The relationship can only ultimately work if mutual commitment is in place.
• For some reason, most organizations under-estimate the impact of commercial consequence on behavior. Is it because many people (naively) expect performance without reward? Commercial consequence should be in place as part of a properly structured commercial agreement.
• It is important to make financial people understand that there is upside AND downside and that the downside can have benefit in other places in the organization.”
The world of trade-offs, is also an area of spend where supply chain professionals need to HELP financial people:
“Starting with the inter-departmental trade-offs: the benefit achieved in production, sales or marketing (or procurement) must be quantified – and compared to the additional cost in logistics or visa verse.
We also need to understand what drives logistics cost and, whether variances result from operational performance issues (good or bad) or whether they are driven by product mix, geography, order quantities, etc.
Finally one must not over-look the most under-measured disruptions in the supply chain i.e. to actually understand the end-to-end impact of promotions.”
Cobus Rossouw is the CEO of Volition a consulting firm specializing in supply chain integration. They have advised extensively in the strategic sourcing of logistics and other key commodities.