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Friday, September 30, 2011

Preparing For the Negotiation

In procurement negotiations the preparation needs to start at the pre-qualification stage where you not only identify whether a Supplier is qualified, but can also look at the cost impact of what they do and how they do it and you can identify any potential problems that you may need to address in your bid / RFP or contract.

The second step in preparing is internal information gathering so you understand what your internal customer needs or wants so you can set your goals and minimums.

The third step is preparing the right bid or proposal documents to both set expectations of what you want and solicit information and options you may want to consider.

When you receive a bid or proposal, you need to analyze it so you understand what the expected issues and will be to prepare for them in the negotiatio. Part of the analysis can be going back to the supplier seeking clarifications on what they have proposed, For example if you provided a draft agreement, you would analyze the Supplier's redline. Look for added conditions, limitations or assumptions that their
proposal was based upon, Seek clarifications on those and consider the impact those will have on the contract and the negotiation. If there are some that you won’t or can’t accept, tell them that to set expectation in advance that those will need to be changed.

Next comes deciding upon what the negotiation strategy should be for the negotiation, developing a negotiation plan and gathering all the tools and team you will need for the negotiation. As the negotiator you need to have built the knowledge or skills to do the negotiation or you need to make sure you have the right people on your team to support you. I would gather the team to make sure they are all aware of their roles and set ground rules for them for the negotiation. You do this to make sure they don't do something during the negotiation that negatively impacts the negotiation.

After you are prepared you schedule the negotiation and provide an agenda. If the other party prepares the agenda, review it to see what’s missing.

Review the other party’s team to make sure that they have a decision maker attending. If they don’t, ask for one to attend.

Want to learn more? The companion book "Negotiating Procurement Contracts - The Knowledge to Negotiate" is now available on Amazon.com.

Thursday, September 29, 2011

Milestones and Progress Payments

When you have a contract where the performance will run over an extended period of time, most suppliers either can’t or won’t wait until the completion of the performance to get paid. This means that it will be necessary to negotiate some form of payment schedule.Many times suppliers will want either advance payments or they will want to “front end load” the payment schedule so they are financing the work with your money. Both of those approaches pay the Supplier more than the value of the work that has been performed at the time and can create problems. With any type of advance payment there are four things to consider.

First, advance payment impacts the cost to you if you needed to terminate the work. This limits your flexibility and may force you to stay with a problem supplier rather than lose that money.
Second, is the Supplier financially stable, where you payment will not be at risk. If you made an advance payment to an unstable supplier at best you would have a purchase money security interest in the product, at worst you would be an unsecured creditor in the event the Supplier ever went bankrupt.
Third is the leverage you lose in getting the job completed on time, especially if they already have been paid a significant amount of the contract value.
The forth aspect is the cost money. To pay them in advance you needed to either borrow the money or it took money away from other uses for that money that could have provided you a return on that money. An advance payment provides no return on the investment to the buyer, only a cost.

If you don’t want to make advance payments Suppliers may want a specific payment schedule for payments on specific dates. The problem with a date-based approach is dates alone have no link to performance of the work. You could have a Supplier that is way behind on the work and paying them on a specific date can create what is effectively another advance payment as they have not earned the amount of the payment.

There are three primary ways that you can avoid these problems. One approach is to establish specific milestones that are based upon the completion of identified deliverables and have a milestone payment reflect the value of the completion of that work and the acceptance of those deliverables. In doing this, your contract would need to specify the deliverables that must be completed or provided to meet the milestone, and the requirement that those deliverables must be accepted as a pre-condition of payment. The acceptance requirement prevents you from paying for deliverables that need to be corrected.

For contracts that may not have specific milestones, payment can be structured based upon the percentage of completion of the work. For example many construction projects have payments managed based upon the percentage of completion of the work as measured or established by a third party. For example if you used the UK building approach with quantity surveyors, they would establish the amount to be paid by their measurement of the work. If you didn’t have a quantity surveyor it could be the architect or engineering firm that would determine the percentage of work completed.

For both approaches the use of retainage is always a good idea. Retainage is the concept of withholding a specific percentage of the payment until the work is complete. You use retainage
as leverage to ensure that the work is completed. The supplier doesn’t get paid the retainage
until all the work is completed. There are a number of different ways that you can structure retainage. You could have retainage be a flat percentage that is retained from payments throughout the agreement. You could have the flat percentage up to a maximum amount after which no additional retainage is withheld. You could have a structure where upon the completion of a specific milestone a percentage of the retainage is released. For example in construction you could have two milestones that are defined. One is “substantial completion” where all the work is complete except for a minor punch list of items that need to be corrected. The other is final completion or final acceptance where all work has been completed and accepted per the terms of the contract. At substantial completion you might agree to reduce the amount of the total retainage and only after final completion or final acceptance is the remaining portion of the retainage released.

Progress payments terms can also be structured to manage performance. For example if a Supplier is late in meeting a milestone you could include language that if the Supplier is late by X number of days in meeting a specific milestone, that payment and subsequent milestone payments will not be made until the progress of the work is back on schedule. That forces the supplier or contractor to weigh the costs that would be required to get the work back on schedule versus the cost to them of not getting paid until they do.

Progress payments with retainage also helps in the event of a default by the supplier. Since the Supplier hasn’t earned the right to be paid the retainage when they defaulted, you have the amount of that retainage you can use to help complete the work.

Want to learn more? The companion book "Negotiating Procurement Contracts - The Knowledge to Negotiate" is now available on Amazon.com.

Wednesday, September 28, 2011

Liens and waiver and release of liens.

The simple definition of a lien is a financial claim against the ownership. For example, if you purchase a house and take out a mortgage, the mortgage company will place lien against the property in the amount of the mortgage. If you purchase a vehicle that you finance through a
Bank they will place a lien against the ownership title to ensure that they are protected. You can’t sell it and provide the Buyer with clean title as you have liens against it. You must satisfy those liens before they will provide an appropriate release so you have clean title.

There are other types of liens that the laws may provide. For example,in construction subcontractors and material suppliers do not have a direct relationship with the buyer.In many jurisdictions laws will allow them to protect themselves by being able to place a lien against the property where that the subcontract work or materials were used. These are commonly referred to as Mechanics and Materialman’s Liens.

As a Buyer, if you contracted with a supplier to perform the work and the supplier failed to pay the subcontractor or material suppliers, you could wind up paying twice. The first payment is the one paid to the supplier who didn’t pay the subcontractors and material suppliers. The second payment is what you would need to pay those subcontractors and material suppliers to release their liens so you have a clear title to the property.

There are two ways that you can mange against this risk. One way would be to require the supplier to provide you with a Payment Bond that would be issued by an insurance company (surety) that would provide a form of guarantee of payment. If the supplier failed to pay, you could make a claim against the surety for payment. Bonds add cost and the ability of a supplier to purchase a payment bond or purchase one without a performance bond may be limited.

The other approach that minimizes the risk is to require a waiver and release of liens from the subcontractors. The way this works is as follows:
For every invoice the supplier submits you require them to provide the list of subcontractors and material supplier portions of the invoice and the amounts applicable.
For the first invoice you would pay the supplier the amount of the invoice.
As a pre-condition of your paying the second invoice you require the supplier to provide you with a signed waiver and release of liens showing that the payment that was initially invoiced on their behalf has been paid.
The second invoice could be invoiced and scheduled for payment according to the agreed payment terms, but the actual payment would not be released unless the supplier provided all the needed waiver and release forms. The same would occur for each subsequent invoice.

Each waiver and release of liens reduces the potential amount of any lien those subcontractors and material suppliers could have. It limits the potential exposure of liens to only one month’s worth of payments to those subcontractors and material suppliers. The supplier can’t skip paying a subcontractor and getting the waiver and release as that means they won’t get paid. Where this also helps is if the supplier were in default of the agreement and you needed to complete the work. Since you wouldn’t have overpaid them more than the work was worth, you would have what’s left and any retainage available to complete the work.

Want to learn more? The companion book "Negotiating Procurement Contracts - The Knowledge to Negotiate" is now available on Amazon.com.

Tuesday, September 27, 2011

Working with suppliers to reduce cost

When many companies were vertically integrated there would always be discussions between
manufacturing engineering, quality and service functions with the design community. Manufacturing engineering wanted a product to be designed in a manner where it could be easily manufactured. Quality wanted a design where they knew it could be produced in high volume in a high quality manner. The service function wanted a design that if there was a failure to the product, it could be quickly and easily diagnosed and repaired or replaced using field replaceable units (FRU’s). The goal of all these activities was to keep the production and life cycle costs of the product they made down so they could be more profitable.

With the advent of outsourcing many of those internal checks and balances have gone away. That because very evident to me when I helped friends with a contract manufacturing company and saw the
way even just circuit card designs were being provided. Most needed to be "re-spun" or re-layed out so the design would fit on the circuit card and so high speed automated placement equipment could be used.This means that when you do high-value negotiations its important to have a supplier that will perform those roles. If all you do is look for your supplier to build or provide you with exactly what you have specified, many will.The cost of that may be far more than you needed to spend. If you can establish a relationship where you can work together to explore ways to reduce the cost a number of things happen.

First, you get the benefit of their experience in being able to review the design or requirement and question why certain expensive items are specified and whether they are needed. You get the benefit of them being able to look at the product, service or solution and what it would cost them to provide as it is currently designed and suggest ideas to: make it simpler to provide; reduce the amount of labor involved; and improve the quality. If you have a product that is difficult to produce you will pay for that in your product cost. The supplier can also look at design from a repair perspective to make sure that its able to be quickly and easily repaired.

If you only provided a list of functional requirements rather than a complete design being able to closely work together can allow them to understand the need for the requirements,and what the costs would be to meet those requirements. It allows for sharing of assumptions they included that simply may not apply and could be eliminated with the cost eliminated.

Most important, without the sharing they will go on to produce what you told them to with all the unnecessary costs built in to their cost structure and will be doing so according to their assumption of what you want or need. Since all those costs are real to them, your negotiations to reduce the cost becomes more difficult because to give you what you want, if they can’t change any of those requirements, the cost reduction must come from their profit.

If you were to work with the Supplier from the beginning and listen to them what you should get is a product, service or solution that costs you less. It’s a win for you and it’s a win for them as while the cost has been reduced it hasn’t impacted their profit. By having a product, service or solution that costs less from the beginning,the need to reduce the cost should be less.When you do need to reduce cost in the future you can work with the supplier to identify other potential ways to reduce the cost that gets you what you need that may not impact their contributions to overhead and profit.

In the end if you can’t find a way to reduce the cost you can still go after their contributions to overhead and profit. That negotiation may be a little easier because prior to that point those weren’t already impacted by prior reductions. If the supplier helps you win by helping you reducing your cost, they shouldn’t lose.

Monday, September 26, 2011

Inflation Indices

At some point in every procurement person’s career you will encounter a period of higher than normal inflation. If you are really unlucky you can encounter one with hyper-inflation. I had that experience as I needed to contract to construct a plant in Brazil during a period of hyper-inflation. What is hyper-inflation? In Brazil at the time he inflation rate was three percent per day, ninety percent (90%) per month or something like thirty thousand three hundred seventy seven percent (30,377%) per year. While it would have been much easier to pay in dollars that didn’t have the inflation rate, the law in Brazil required that
all contracts in Brazil had to be paid for in Brazilian currency, which at the time was Cruzados. This meant that virtually every purchase that didn’t have immediate delivery and immediate payment and every contract that had an extended performance period needed to include an inflation index.

The first decision that I needed to make was which inflation index should I use? The government published an inflation index that many believed understated the level of inflation. The banks published their own inflation index that many people considered to be more accurate. Contractor’s groups published their own inflation index that our financial people in Brazil though overstated the inflation. Working with our financial people we decided to go with a blend of all three where the inclusion of the government index would offset the contractor published index that we thought overstated the inflation.

Establishing the index was the easy part. The more difficult part was when it came to invoices and payments. Invoices were based upon the original contracted price for the work that had been performed. Those invoices then needed to be adjusted based upon the inflation that had occurred from the original contract date to the date of the invoices being submitted. Payments needed to be immediate so they weren’t also subject to inflation. This meant that an item that had an original contract value of CZ100,000 the invoice after 30 days required a payment of CZ190,000, It it was paid after 2 months it would be CZ361,000. After three months it would have been CZ685,000. Each additional period was increased by the compounding effect of the inflation. The amount of administration that was require to calculate the payments was significant as the further out in the contract you went the more the amounts needed to be compounded and every month could have a different rate based upon the average of the indices. Toward the end of the work each monthly payment was more than the original contracted price.

For every change that changed the contract price those changes weren’t calculated from the original date of the contract, they were calculated based upon the date that the cost of the change was agreed and then payments for those changes were subject to the inflation index from that point until payment. This meant that you had to not keep track the inflation that occurred for each change.

My biggest concern in the process was not the inflation itself but that the payments were being correctly calculated. The reason why I wasn’t concerned was my budget was in U.S. dollars and when we needed to purchase Brazilian currency to make payments, the inflation also affected the currency exchange rate so as inflation went up, the amount of Brazilian currency that we purchased with the dollar increased at the same rate as the government published inflation rate.

If you ever need to enter into an agreement where an inflation index is required there are two things I would suggest. One is work with your financial or treasury people to help determine what rate or blend of rates you should use. Make sure that you have people that can help you with the calculation of what should be paid.

From a contracts perspective the changes you need to make to a contract for inflation is first to establish the agreed indices. You need to establish the administrative requirements for invoicing. You may need to negotiate a different payment term, especially if the inflation rate will be high. Other things like determining what the value of the work would be for making milestone or progress payments should be no different. You do need to be concerned about the supplier wanting to front end load the payments. Whether you agree to do advance payments on certain items to avoid inflation would always need to be weighed against the risks inherent with advance payments ..

Friday, September 23, 2011

Intellectual property rights - work for hire clauses

Ownership of the supplier’s work product that is commonly addressed “work for hire clauses” is an item that is frequently negotiated. Most buyers are of the opinion that if I pay for it I want to own it. Most Suppliers will have the attitude that I'm bringing all my existing knowledge into this that the Buyer isn't paying for and therefore I should own it or have rights to it. In drafting and negotiation such a clause they key is to understanding why you want it or need it and thinking about why the Supplier will want it.

For items that are copyrightable a work for hire provision is usually there to allow the buyer to have free use of the item in any way they want without having to go back to the supplier each time they want to change something or use it in a different manner. For items that could be patented buyers may want to have ownership for the potential revenue a patent may bring or to have a competitive edge in the marketplace. The last thing you want to do is pay for the development, and have the supplier be able to sell the same thing to the competition for far less than what you paid.

Frequently having 100% ownership of all rights by the Buyer may not work and if you insist upon having them and the supplier agrees, you will pay a premium for that work so total ownership may not be always the best answer.

Letting the Supplier have total ownership may be cheaper in the initial cost, but if you will need to change or modify it, since the Supplier would own the intellectual property right, you would need the Supplier’s approval to make any derivative work, and that can force you into having to go back to the Supplier to have them do each and every change and that can be costly.

In most negotiations the parties can usually find an acceptable middle ground. There are many alternatives available depending upon what the motivation is for ownership on both sides.
The most common variables are who owns it? What license grants to use it are provided?
What restrictions are there on use such as who or what it may be used with or when may it be used? Here are several examples:
1. The buyer could own work product and give the supplier an unlimited right to use it for a license fee. That approach helps recover some of your investment if there are other potential uses.
2. The buyer can own the work product and give the Supplier the right to use it for a fee, but restrict where or with whom it may be used. That approach would be used if you had competitive concerns.
3. The buyer can own it, and allow the supplier to use it without a license fee after a specified period has been exhausted. You could use this approach to allow them to freely use it as competitive value only lasts so long.
4. The supplier can own it where they give the buyer the right to use, modify, etc. make derivatives or, and sublicense the use. That approach keeps you from having to come back to the Supplier each time you want to change or modify it. In this approach I would want to pay significantly less for the work.
5. If you will be jointly involved in the activity where both parties may create patentable or copyrightable items, the Buyer could own what they individually create without any license grant to the supplier on the buyer owned intellectual property and the supplier could own what they create with appropriate license grants to the buyer for the supplier owned intellectual property.

Bonds and Bank Guarantees

In my February 6, 2011 post about managing supplier performance I mentioned some of the financial tools that can be used to help manage performance. Those included the use of items such as performance bonds, bank guarantees, liquidated damages provisions, penalties, releases of progress payments or a delivery date based pricing (with bonuses for early delivery, or credits for late delivery). Today I want to discuss performance bonds and bank guarantees.

A performance bond is a document usually issued by an insurance company (“Surety”) that normally will commit up to the full value of the contract to complete performance if the supplier fails to complete the work. Suppliers or contractors purchase the bonds from the Surety and the cost of the bond will be dependent upon how the Surety perceives the risk of the supplier performing which is largely based upon the contractor’s financial condition. If the supplier defaults, the buyer or owner will make a claim against the bond with the Surety. As a condition of the bond with the Supplier or Contractor, the Supplier will commit to assign the contract and any subcontracts to Surety. As a condition of collecting on the Bond the buyer or owner must agree to allow the Surety to finish the work or hire someone to finish the work. The Surety’s primary goal is to complete the work for the lowest possible cost to reduce the amount they have to pay.

A bank guarantee is different. Normally to obtain a bank guarantee the supplier or contractor will either need to have money in deposit at the bank that will be used to provide the guarantee or they may need a line of credit with the bank that is secured by the Supplier’s assets. Bank guarantees, since they are tying up either the supplier’s actual cash or a portion of their available credit will be much lower, many times as low as ten percent (10%) of the contract value. Bank Guarantees can be direct where payments are made to the holder of the guarantee or they can be indirect where payment would be made to the holder’s specified bank. The specific conditions and process for collecting against the bank guarantee would be spelled out in that document so you need to read it so you see exactly what you are getting and whether that meets the requirements of your agreement for the bank guarantee. Bank guarantees could specify similar requirements to a performance bond where they would be involved to manage the amount paid.

While you could technically require both a bank guarantee and a performance bond where the bank guarantee would be like a deductible to the performance bond, most suppliers wouldn't agree as that both ties up their money or available line of credit and the bond adds additional cost.

While both performance bonds or bank guarantees provide some degree of financial protection against default by the Supplier, many times buyers may not want to have a third party involved in the process whose sole goal is to minimize the cost of completion. If you want to control your own destiny without third party involvement, bonds or bank guarantees may not be a route you want to take. In that case your contracts need to include rights in the event of default. Those rights would be triggered by the supplier’s failure to cure the breach of the contract. Those rights could include hiring their personnel, use their equipment , and having assignment of all subcontracts to you to allow you to complete the work.

If that’s a direction you plan take you need a detailed qualification of the supplier or contractor before you start to minimize the risk. To make sure that you don’t have a large number of unpaid subcontractors the contract should require the supplier getting waivers and releases of liens from subcontractors for the amount of their work included in the prior invoice as a condition of payment to the contractor to make sure the contractor has paying the subcontractors. The agreement should include holding sufficient retainage at all times so if needed, you can use that money to complete the work. Lastly as bonds usually cost a percentage of the contract price, if you don't require them you also have that amount of savings you could add to what it takes to get the work done. Lastly, you also could claim breach and seek damages for both breach of the contract any for any excess costs to re-procure the completion of the work if the Contractor still had any money.

Thursday, September 22, 2011

Letters of Credit

Letters of credit are used when there are concerns over potential payment especially when dealing with international transactions. They can be an alternative to requirements for requests for advance payments by suppliers. In a letter of credit a Buyer would contact an issuing bank to create the Letter of Credit on Behalf of the Buyer. The bank would reserve money in the Buyer’s accounts to pay for the letter of credit.The supplier who will be the beneficiary of the Letter of Credit will select the advising bank in their location where the funds will be transferred.

One requirement of a letter of credit used with procurement is that it must be irrevocable.That way the supplier knows that the funds will be available when they ship. Buyers place certain requirements that must be met for the payment to be made.These include the date(s) by which the shipments must be made, a requirement for a commercial invoice that complies with the requirements of the agreement as that is needed for import purposes. The bill of lading that describes what was include in the shipment and that it was shipped.It will also include other documents that prove the supplier complied with the contract requirements. Those requirements can include proof of insurance if insurance was required to protect the items during transit or proof of export licenses if the supplier was responsible to obtain the export license.

Letters of credit may be written to be either payment on sight or on specific dates or terms after delivery. Sight means that there will be an immediate payment upon presentation of all the documents that are required by the Letter of Credit. Date or term payments are similar to net terms where payment is made on a specific date or terms after meeting the Letter of Credit obligations. If the supplier fails to meet one of the obligations they do not get paid. If the obligation was for a specific delivery date and the supplier was unable to meet it,the letter of credit would need to be amended for payment to occur.

There are alternative to letters of credit. For the most part they are not balanced. Approaches that are good for the seller have higher risk for the buyer and vice versa. The best way to always protect yourself is do your homework in advance and only deal with business partners that you trust.

There was a post in Linkedin about a company being abused by a Supplier where they had made an advance payment to the Supplier, only had received 20% of the order and the Supplier was demanding a new larger order as a condition of shipping the balance. The question was what would you do and I thought you might enjoy my response which directly ties to this post.

“I would never pay anyone in advance for goods. If the supplier has a concern about your paying them I would provide them with a bank funded letter of credit. Letters of credit protect the Buyer because to collect they would have to meet the requirements of the Letter that require providing proof of shipment of all the materials, not part. If they ship less they don't get paid. If they claim they have shipped all but haven't its then a criminal act of fraud.

For other types of purchases after doing the due diligence they should have done. if I still had any concern before giving them the agreement I would consider requiring a performance bond in the amount to the value of the work. That gives you another party you can go after to complete the performance if they don’t.

Assuming that you made the mistake, I would absolutely never give them any more business or orders as all that they are doing is a form of extortion. I would use the information of their actions to terminate the agreement for cause. I would send them a cure notice. When they fail to deliver, I would then send them a termination notice. Then the decision comes down to whether its economically viable to go against them in court to not just recover the part of the payment that they didn't earn but also to collect any damages you have sustained for the excess cost of re-procurement (cover). If it isn't chalk it up to an expensive lesson on how to not to conduct business.

You could possible assign your rights to a third party that could go after them, That's similar to companies selling their receivables. They would pay you pennies on the dollar but that may be better than nothing.

Lastly, before posting any information about your experience with the company on any websites, I would also talk with your attorneys to coach you on how to do that without being subject to libel or slander claims. Any company that would try to extort you into giving them more business is the same type of company that would come after you claiming libel or slander of their “good” name.

Wednesday, September 21, 2011

Confidentiality – Marking Requirements and Oral Disclosures

This is a supplement to the blog posted on April 7, 2011 on Confidentiality Agreements. The focus of this post is on marking requirements and oral disclosures

Marking of confidential information is extremely important for a number of reasons. First, if you don't require marking you would need to manage all correspondence you receive from the other party as confidential. That requires a higher standard of care for you to manage it and cost you more. Most correspondence between companies simply do not warrant treatment as confidential information. It should be limited. Second, and more important, when you receive confidential information what you are receiving is a company’s trade secret information. Just like any other proprietary right, you can be liable if you use or disclose that information in violation of the confidentiality agreement. If you use it, you become subject to misappropriation of trade secret claims. If you disclose it to others, you will have breached of the confidentiality agreement. Since receipt of confidential information creates potential liability you want to limit and control what you receive that is subject to confidentiality obligations. You don't want the supplier sending you all types of information that could cause problems or increase your risk and that also applies to things that are disclosed orally.

Confidential information being disclose under a confidentiality or non-disclosure agreement should be limited to only what you ask for. That should be further limited to only information that meets the criteria for trade secret information:
1. It is not generally known to the relevant portion of the public;
2. It provides an economic benefit to the discloser that is not generally known;
3. The discloser uses reasonable efforts (both internally and externally) to maintain its secrecy.
It should not include copyrighted or patented information as the discloser is already protect on those. It should never include all correspondence.

It needs to be marked so there is no question that it is confidential and would be subject to the requirements of the agreement. Suppliers may not like the extra work for them of marking it, but that shouldn't create both increased management costs and increased risks for you that would occur if they don't. Further the need for them to use reasonable efforts to manage their information as secret should be sufficient for suppliers to want to mark documents as otherwise they could lose the protection. If you run into a supplier that doesn't want to mark information, they will generally want all the information that's shared to be considered confidential. As a recipient that's not something you would want as is dramatically increases the potential risks to your company.

How do you do marking when the disclosure is done orally? If you are going to allow oral disclosures you need to keep the number of them limited so they will be managed. Your confidentiality agreement or non-disclosure agreement (NDA) should require several things. First, at the time of the oral disclosure the discloser must identify that information as confidential. That way the recipient knows that it is confidential and they will be able to manage it accordingly. Second, the agreement should also require the discloser to immediately send a notice confirming the disclosure and what was disclosed orally. That way it’s not just one person’s word against the other. That way if something was disclosed to an engineer, and the contract manager is the one that manages and documents the receipt of confidential information they will get that notice of the disclosure. The burden of confirming the disclosure should always be on the discloser, if it’s their information to be protected.

Tuesday, September 20, 2011

Counterparts help speed up contract signing.

Many companies and procurement groups follow a serial form of signature process. They send the contract out to the supplier for signature,and then wait until they get the handwritten signed copy back, which they sign and distribute.If the contract is with more than one party such as a buyer,a supplier and a number of the supplier’s subsidiaries in various countries around the world,even with express delivery that process can frequently take a long time.

If you are contracting in a jurisdiction where the laws recognize other reliable means of documents as an original (such as photo or scanned copies that are faxed or e-mailed), you can shorten the time it takes by moving to a parallel process.

To do that in the contract you need language that documents the intent of the parties that anything made by reliable means shall be considered as an original. That allows you to use either photocopy that is faxed or scanned copy that emailed. Both document approaches would be considered as creating originals. You also need to include language establishes the parties intent to allow the agreement to be signed in what’s called “counterparts” and have each counterpart be deemed as an original. For example: “This Agreement may be signed in one or more counterparts. Each counterpart will be deemed to be an original. All counterparts when taken together will constitute the same agreement.”

You can use this approach where its just you and the supplier. Send the supplier the agreement to be signed. Have them sign it, scan it and send it back to you. Print out the signed, scanned copy.
Sign that and scan it and send that signed scanned copy to the supplier. Both of you know have what would be deemed to be signed originals. Where it becomes even more of a time saver is when there are multiple parties such as a buyer, supplier and a number of supplier subsidiaries.
Adding those statements to the agreement would allow you to electronically send the agreement to each of those entities. They would sign the agreement in their appropriate signature block and would send the copy they signed back electronically (fax or scanned copy). You can sign and send that back electronically to them following they same manner or via hard copy. That creates one counterpart agreement. The same process would be done in parallel with all the other parties. If you had a supplier and 5 subsidiaries, you would have the agreement created in six counterparts. Those six counterparts constitute the same agreement per the terms of the agreement.Suppliers may want to collect all of them and send it as a package or buyers may want to await receipt of all of them before they sign each of the counterparts. By doing it in parallel rather than serial, as long as all the signatories are ready to sign when they get it you get an agreement signed in a matter of minutes or hours, not many days.

Always check with your local legal support to ensure that they agree with using this approach and that it would be enforceable in your jurisdiction and the jurisdiction of other signatories to the contract. .

Monday, September 19, 2011

Hedging Currency

In my March 17, 2011 post I discussed foreign exchange. Today I want to expand upon the concept called hedging.

If you agree to pay in another currencies there are basic three options available:
1. You need your company to generate those funds from sales into that country where payment is in the local currency. Funds generated in this manner provide what is called “a natural hedge” against currency exchange changes as you already have that currency available for your use.
2. You can purchase the funds in advance from the financial marketplace in what is called a "hedge contract". The cost to buy foreign funds for future delivery is called the forward rate. Forward rates are published in financial papers and internet financial sites.
3. You can pay by exchanging currency at the date needed to payment. This type of a purchase is called a “spot purchase”.

For those companies which don't have a natural hedge, or where the natural hedge isn't sufficient to cover all the local expenses and purchases, and you jave agreed to pay in local currency, it's necessary for buyers to consider whether to let the exchange rate "float" (make a spot purchase) or purchase a “hedge contracts”.
The forward exchange rates are established based upon market factors such as: the available supply and demand, the timing of the purchase, the risk or volatility with both currencies, and the currency changes that currency traders predict.

Hedge contracts are expressed as dates in the future and are called forward rates. You can have 30, 60, 90, or 120 day forward rates, etc. A hedge contract is a commitment today for the buyer to purchase and the seller to sell the agreed amount of currency agreed at the agreed price at that agreed time increment in the future.

The decision of the buyer on whether to hedge then becomes:
1) Is there any perceived currency risk to be managed?
2) If there is risk, do I let the rate float or do I hedge?
3) If I hedge, how much do I hedge through a forward rate?
4) If I hedge, when do I hedge and for what forward rate periods?

The decision on hedging also ties closely to the accuracy of forecasts. If Buyer’s trading currency is strengthening versus supplier’s currency and you buy less than, equal to or greater than the amount forecasted the hedge provides no value, only a cost Where forecasts are important is if your trading currency is weakening versus the supplier’s currency. If actual purchases are less than forecasted, you get the benefit on the purchases made, but you also incurred the cost on purchases not made. If the actual purchases are more than forecast you get a win from hedge that protected the forecasted amount, but that benefit will be offset by the incremental cost to purchase funds the addition funds needed at the then current spot rate. It is only when the actual purchases are as forecasted that you get the maximum value for purchasing the hedge contract.

The shorter the window between purchase commitment and payment, there is usually less of a risk as long as the financial markets are stable. The best price is usually in the local currency of the supplier as it takes most currency exchange concerns out of the supplier’s pricing. Forcing U.S. dollar denomination pricing will cause the currency risk to be shifted to the supplier, and the supplier will build in contingencies. You should only agree to pay in the supplier’s preferred currency when that leads to cost savings or when your company has natural currency hedge at no additional cost. If you don’t have the skills, always pay in your currency and if you must pay in foreign currency always involve your company’s Treasury department or their expert in foreign exchange or hedging decisions.

One final comment. Frequently buyer’s may seek to avoid currency exchange issues by paying in their preferred currency using what is called a band width contract. In a band width contract the price is fixed in the Buyer’s currency as long as the currency exchange rate stays within agreed band that has upper and lower limits.
Band width contracts favor suppliers. At the worst point in the band for the Supplier they will still make money. At the best point in the band for the supplier they will make even more money. If the rate goes below their worst point they either don’t have to sell or they can re-price based on the change. If the rate goes above their best point, the buyer can re-negotiate, but what they are re-negotiating against was position that was already the best for the supplier.

Let me show you an example. Today’s exchange rate between the U.S. Dollar and Japanese Yen is 76.745, meaning one dollar is equal to that amount of yen. The Japanese supplier has a product that costs ¥7674.50, which equals US$100.00. You agree that the price will be US$100 as long as the exchange rate is between ¥70 and ¥82. The best rate for the supplier will be at ¥82 as the Dollar will buy more Yen. The worst rate for the supplier is ¥70 as it purchases less Yen. In agreeing to the band the supplier knows that they will be profitable even at ¥70. They will be even more profitable at ¥82. If the rate goes below ¥70, they either don’t need to sell or they can re-price so they never lose. If the rate goes above ¥82 the buyer can re-negotiate, but that re-negotiation is against their already best price of ¥82.

Friday, September 16, 2011

Sales approaches

There are a number of different selling approaches. A good brief article about the different types of sales approaches can be found at: http://buyersmeetingpoint.com/the-flip-side/sales-101-for-buyers

In addition to the different general selling approaches there are also a number of different sales focuses. The sales approach or sales focus are frequently intended to drive buyers away from negotiating on a cost basis.

Cross selling as part of servicing an account, offering additional or add on service is something that we see every day. Have a bank account? How many other products or services has that bank tried to sell you? That’s cross selling in action. The goal isn’t to help you. The goal is to use the existing relationship to have you use them instead of others and not consider any differences that may exist between their products or service and their costs versus others.

Solution selling has been one of the most common approaches to selling. Years ago I read Xerox sales training materials that were focused on solution selling. First you identify the problem or pain the customer has. Demonstrate how the features of your product or service help solve that pain. Convert those features into benefits that the customer will see and be willing to pay for. The goal in solution selling is not just to make the sale, it’s also to differentiate your product from the competitions so you can charge a premium over the competition. When buyers see solution selling, they need to do feature / value assessments to determine if the difference in the features provides significant incremental value to substantiate any price difference.

Up selling is sales approach that you all should be familiar with. A company advertises a low price product and as soon as you get there they try to get you to purchase something different that costs more. I also think there is such a thing as down selling and that usually occurs when a buyer sets a target price they want to pay for an item and rather than negotiate price on the original item they offer a different lower cost model that fits within the Buyer’s targeted price. The goal of down selling is rather that sell for less they want to give you less.

Value added selling is not much different that solution selling. It’s focus is on highlighting the value a product or service will provide, again needing the customer to convert that potential value into a benefit that customer will be willing to pay for. Suppliers want to use their unique value to differentiate themselves from the competition so they can charge more. In my December 15, 2010 blog post I wrote about the concept of value equivalence that some companies use for strategic price setting. Value equivalence is also a tool negotiators can use to negotiate cost. If you know what others charge that don’t have that feature you can identify the incremental cost a supplier is asking you pay for that additional feature. Use that difference to negotiate a better price that is consistent with the real value of the what’s different, not the price they want to charge. Make sure that the Supplier doesn’t know that you need or want that feature so you can use the other products as competitive benchmarks.

Return on investment or ROI sales approaches are intended to do two things. First, it is to make the sale easier.What could be easier than buying something that pays for itself? It’s also intended to get the focus away from negotiating cost and have you focus on the savings you will get from the purchase. You’ll save even more if you purchase it at the right price, so don’t be blinded by the savings. Always think about the cost.

Companies also have selling focuses that are intended to try to reduce your negotiating on a cost basis. It can be the prestige of the company or the product or services they sell. It may be the distinctiveness of their product. It can be the simplicity of doing business with them. It could be the design or aesthetics of the product. They could have planned limited availability of the product where “only a select few” can buy it. Service support and commitments to customer satisfaction can do it. Having unique or special things that other suppliers don’t offer can also do it especially for a unique portion of the customer base. A good example of that in today’s market are products that are green / environmentally friendly. Want to bet that a large percentage of those are sold at a premium over products that aren’t green? Every go to a grocery store and see regular tomatoes and organically grown tomatoes? The organic ones always cost more. Does it really cost that much more to grow them organically or are they just charging a premium for customers that want to buy organic? Every company that has these individual selling focus has or will negotiate on price, they would just prefer not to because if they can avoid it they make more money.

If you walk through the door of a Rolls Royce® dealer and they have only one car in stock a sales person will react differently than if they had 20 sitting in inventory that they had been paying floor plan interest on for a while. In the first example the selling attitude may be that “if you need to ask the price you probably can’t afford it”. In the second example the attitude would probably be more like “let’s find a way for you to take this car home today”.

The more you know about sales, sales approaches,sales focuses and sales channels,the better prepared you are for the negotiation.

To learn about channels check out one of the April 11, 2011 posts called Channels.

Thursday, September 15, 2011

YES PEOPLE AND NO PEOPLE

In Business there are people who are “No People” either because it is their job to say no, or because saying no and getting the customer to accept no will help them meet performance metrics upon which they are measured and rewarded.

“Yes People” are those within a company who are above the level of the “no person” and are not measured in the same manner. They can look at the decision from a broader perspective as they have a broader base to measure against.

Frequently the sales person is a “No Person” as making concessions to you will potentially affect their measurements or rewards. Many times a sale may be lost by the sales people that are unwilling to make concessions or that don’t want to admit to their management that they misread the customer and what would be needed to close the deal. If you deal with the sales manager or higher in the organization you will be dealing with someone who can look at the concessions from a different perspective. They can look at all of the business they are responsible and this increases the chance of getting what you need or want.

Service people, especially those people who handle claims, complaints etc. are also for the most part “No People”. Frequently their goals and measurements are to give out as little as possible as. If you escalate your problem or issue up the chain you will have a greater likelihood that you will finally reach someone who either can view it from the broader perspective, or is measured differently or who has service and customer satisfaction as a real concern. When I have problems with service people in a company I always involve the sales person so they know that it may impact their future sales.

It is not hard to think about all the every day life situations where you encounter “No People”. Companies always arm “No People” with tools to help them. For example, if you want to return something or make a claim on warranty they will always ask for your original sales slip. Why? They want to intimidate those who can be intimidated to accept that nothing can be done without it. In most instances if you are able to get to the right person you will not need it. In most instances the “No People” are so hardened from saying no that nothing you do or say will have an effect on them.

Moving up the ladder will require that you communicate in a manner that is appropriate for the other party. In almost all instances it pays to be both pleasant and under control at all times. If you have been pleasant and are making no progress with the “No Person” you may need to be more forceful. However, if you get to the “Yes Person” and start with the forceful approach you run the risk of turning them off and also getting a no from them.

Elevating past the “no people” can also work in getting what some people refer to as the “Invisible Warranty”. Assume that you have a two-year warranty on your car and at 25 Months the paint starts to peal. The “No Person” will simply point out the fact that you had a two year warranty and it has expired and if you would like it corrected they will be glad to do it provided you pay. If you can get to the yes person, the one who is really interested in customer service you may be able to negotiate partial if not full restitution. They may also know that a defect existed which they were prepared to correct but which they would not publicize as it would cost substantially more money. In short, they are prepared to make the corrections but don’t publicize them - hence it being called the Invisible Warranty”

Here’s a real example.
On arriving from a business trip, my trusty car wouldn’t start. The next day I was told that my “computer”, which controlled the gas flow needed to be replaced. As my car had had exceeded the allowed mileage for warranty I was told that it would cost $500 to replace. I knew the dealership would be full of “No People”. I authorized the repair and required I be provided old part. I then took the broken part to an engineer where I worked in the computer business so we could analyze it. What we found was a device that cost probably less than $20 to build and had components with standard reliability of 7 to 10 years or more. At that point I had determined that I was both being abused by the company in the pricing charged, but also had a problem which shouldn’t have occurred as my miles should have made no difference in the reliability of the item. I proceeded to search out the “Yes Person” within the Company’s service organization. Finally I reached a person and explained the facts of my situation, then I noted that they marketed their car with the slogan: “XXXXXX” saves” and pointed out that I hardly considered paying 2000% of the cost to manufacture the item as a good example of “XXXXXX” saves”. He agreed and we agreed that they would refund me the entire cost of the computer, I would pay for the labor (under $100) and they would pay for the tow ($50) and I would return the computer to them. Getting to the yes man saved me some $450.

Every time you elevate an issue to the level of the “Yes Person” you may not get complete satisfaction. Depending on the circumstances and how you approach it, you will be successful more times than not.

Wednesday, September 14, 2011

Price Curves

Every product will have a product life cycle and a product price curve. From the time the idea for a new product is conceived, companies begin to establish their pricing strategies. If you ever worked in a product development atmosphere you know that there is always a push for bring the product to market as early as possible, but did you ever wonder why? It all comes down to money.

If you are first to market with a product with new features, new functionality, you have effectively created your own market where you may charge a premium price. If you are first to market, a goal may be to get designed into other company’s products. That gives you an advantage on pricing with those companies, as to change from your product to a competitor may require a re-design, or re-qualification. Unless your price is so high as to force the buyer to change, they will continue to pay your higher price. If you are first to market, you will enter the market at the high end of the price curve where you will make the greatest amount of profit.

What is a price curve?

When there is only one company selling the product the price will be high. As competition enters, the pricing is usually driven downward. As the market becomes flooded with competition the price is driven down to usually the lowest it will be. As companies exit that market because of the lack of profitability or to focus on new higher margin products, the price will increase. The slope of the price curve will be affected by supply / demand positions. Excess supply will cause it to decline faster. Excess demand will cause it to remain stable or potentially increase until there is excess supply. Significant excess demand may cause a longer product life cycle.

There are a number of factors that will have an impact on the price curve which are the same as mentioned in the blog about the five forces of competition.
1. Rivalry in the market between existing competitors.
2. New entrants that create new possible sources of supply.
3. Substitute products or services
4. Barriers to switching to a substitute product or service are small.

In addition to those, things like delays in new or substitute product or service availability or companies being late to adopt those new products or services will always have an impact on the demand for the existing product and the price curve.

Most price curves over time will look like a hockey stick or golf club that are placed against a wall at a 45-degree angle. The end of the club or stick where it touches the wall represents the highest price where there is little competition. As you follow the shaft town towards the floor two things happen, it gets farther away from the wall and closer to the floor. Think of the distance from the wall as representing increase in competition from new entrants into the market. Thing of the the distance from that point to the floor as representing the decrease in price that results from that increase in competition. Where the shaft touches the floor represents the lowest price point. This is the point of maximum competition and excess supply versus demand has driven the lowest price. The blade or golf club face going up represents price increases that occur when companies exit the market or move to newer higher profit margin products, leaving less supply for the remaining demand.

Supplier may try to avoid following price curves or may try to extend their product’s life through what has been called “mid-life kickers”. All a mid-life kicker represents is the introduction of new feature or performance to the product. It’s an attempt to price differentiate themselves from the competition. The goal is not just to increase sales, but it’s also to slow the price erosion until the competition comes up with similar performance or features.

In managing against price surprises you need to do two things. Understand the life cycle of the products that you purchase. Don’t make long term commitments when a product is early in its product life cycle as the prices will most likely be driven down by competition. As you near the end of the product’s life cycle make any purchase commitments for future needs before companies start to exit the market. Always monitor the market to see what will affect supply and demand. It can be impacted by a delay in the introduction of a new product or customer’s acceptance of that new product. Be aware of not just what you and your competitors are do, be on the lookout for other products or industries that may potentially use of those products that could put the market into a demand imbalance. Here’s an example that I used in another blog. At one point in time the major customers for tantalum capacitors where computer manufacturers. Then cellphones were introduced. They also used tantalum capacitors. As cell phone purchases grew enormously the total demand for tantalum capacitors created shortages. In a fairly short period the cell phone industry began purchasing more tantalum capacitors than the computer industry. The competition between different industries for the supply created shortages and drove pricing up. If you saw that coming you could have made commitments to lock in pricing in advance.

Tuesday, September 13, 2011

Understanding quoted product reliability numbers.

There are many ways and methods used in estimating reliability of products or software. Many products have their reliability expressed as Mean Time Between Failures (MTBF), which is the expected mean or average time in which the product will fail. In Semiconductors the measure frequently used is Failures In Time (FIT).

Quoted reliability numbers are not a guarantee that the product will last that long. Some products will fail in much shorter periods and others may last far longer. All that goes into establishing the average. The average rates that a supplier may quote are calculated and represent an estimate. They aren’t proven because the length of time to prove them would take too long and would extend longer than the product’s normal sales life cycle. For things like electrical components you can easily have product MTBF's of 100,000 hours or more. That is something like 11.4 years.Supplier warranties may be anywhere between 1 and 3 years, seldom more unless the market demands it.

Unless you can prove that there was a deliberate misrepresentation by the Supplier about the product and its reliability, the only responsibilities the Supplier will have to the Buyer for reliability is what was committed in the sales agreement under the warranty. Quality, reliability, and functionality of the product are all issues fall under the product warranty. The only time a supplier is going to be responsible to provide repair or replacement for any of them is if they fail to meet the agreed specification during the warranty term. Even then the supplier will only have responsibility if the cause for the product being defective is not excluded by a warranty exclusion.

The one exception with regards to reliability is when the parties negotiate what's called an "Epidemic Defects" clause. Epidemic defects clauses usually have coverage that extends beyond the warranty period. In those situations Supplier has additional obligations if certain events occur that would make it an epidemic defect. In epidemic defect provisions the supplier may be responsible for not just the replacement of the defective product but they may also assume some of the buyer’s additional costs associated with having to replace the defective items. As these type of clauses provide substantial increased potential risk and cost to the supplier they will want the definition of what constitute an epidemic defect to be very narrow. They won’t agree that all defects that may affect the product’s reliability will count. They may agree upon a measurement that requires a threshold or percentage of defects for the same root cause to occur for it to be considered epidemic.

Reliability does have a connection to another area of contracts. If the defect in the product causes a safety problem or causes personal injury or property damage other terms come into play. In most contracts in addition to the warranty against defects in material and workmanship there will also be other warranties that apply - the product is safe, the product complies with applicable laws etc.

The warranty against defects in materials and workmanship must survive the expiration of the contract so you get the benefits of that warranty and can get defective material repaired or replaced under the warranty. Those other warranties and indemnities against 3rd party claims for personal injury need to survive and be open ended as to their term. The reason for that is because potential third party claims are not extinguished when the warranty has expired. They are only extinguished when the period for filing a claim has lapsed under the applicable statute of limitations for that jurisdiction. For example in New York, an injured party has six years after they were injured to initiate a personal injury claim.

Many times problems with product safety may also be classified as an epidemic defect and require the supplier to replace those items. In those cases the Supplier isn't committing to replace them because they didn't meet their reliability goal, they are doing it because unsafe products represent potential product liability claims that could cost far more than the cost of replacing the product.They will also do that because in most well written contracts both the warranties for a product being safe and indemnifications against third party claims for product liability will also survive the expiration of the contract where all those costs will be their costs.

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 hbr.org/2008/01/the=five=competitive-forces-that-shape-strategy/ar/1

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.

Friday, September 9, 2011

Disposing Excess and Obsolete Material From a Contracts Perspective

Many companies consider selling or bartering excess or obsolete material to reduce the inventory levels and free up cash. Sounds like a great idea, but it isn’t without potential problems and risks that you should be aware of if you consider it.

First, you should always consider the potential product liability risk that is inherent in the product or with different potential uses of the product. Since you are functioning as a seller that puts you in the sales chain where you can be potentially liable under product liability claims if there is personal injury or property damage caused by the product.

Second, unless you specifically control how it can be used and where it can be used the subsequently use of the product could increase the potential risk and magnitude of the liability. You know how you used the item and the design tolerances that you had. You don’t know how the item purchased will be used or what their design tolerances will be. You purchased the item for use in a specific application. You don’t know what application it will be used in and there are many applications that can be much higher risk. For example if you sell the item to a broker and the broker sells it into a medical products company that makes life support systems, your potential risk is dramatically increased.

Third, you always need to read the terms and conditions and specifications that you purchased the item under.Those will identify whether you can pass thru any of the commitments you received from the supplier. They may also have included restrictions on use that would void any commitment to you if the product were used in one of those restricted uses. Many times suppliers do not allow you to pass anything thru to your customers or may prohibit the resale of the items.

To put the issues into perspective consider the following scenario. The Supplier you purchased from specifically prohibits use in certain applications in their terms to you. You sell the product to a Broker. The Broker sells it into one of those uses. The product fails and individuals are injured. The injured party will sue everyone that was involved in the process.
They sue the party that used it to make the product for high risk use, they sue the broker,they sue you, and they sue the original supplier. The company that made the high risk product is small with little assets. The broker has minimal assets. Your company and the Supplier's company have substantial assets. So paying the claim comes down to you or the original supplier.But you breached your agreement with the Supplier because you either resold it when you weren't allowed to or you allowed it to be resold into a restricted use. This means that you lose the contract protections you had from the Supplier for product liability, and you will be responsible to them for damages they sustain because of your breach of the agreement.Those damages will include those third party liability claims.

Fourth, you need to decide the sales terms that you will sell to the purchaser under. Most of the time since the supplier won’t allow you to pass any of their commitments thru and you won’t want to be assuming risk or liability on those sales. That means the sales will be done as-is, without any warranties or indemnities. That will provide protection against claims from purchaser claims, but it does not protect you against third party product liability claims. Those can’t be disclaimed in most jurisdictions. Since you are now functioning as the seller rather than the buyer you also need to manage all the issues a sales function traditionally deals with such as receivables, refunds for damaged or defective product shipped.

Fifth, I would never sell off any excess item that was proprietary to your company. All that could do is potentially provide a third party with what they may need to compete with you in servicing or repairing your product that used the item.

The alternative to all of this and this is the first step I would recommend is always try to sell it back to the original supplier even if it’s at a significant discount. If the Supplier has demand for the product they won't want you dumping a large quantity of excess on the market as it could depress their sales. You might also get more than if you tried to sell the excess. Buyers will pay a higher price to purchase it because the supplier will offer the full terms. Suppliers will also be happier because they can control who it’s sold to and where it will be used to manage their potential product liability.

Before I would head too far down the road on selling excess material I would talk to your lawyer and get their input and the sales terms they recommend for those sales. What they will want to understand is the trade-off that needs to be made between getting the proceeds of the sale versus assuming the potential additional risks from the sale.There will be some items that may be easily resold that have minimum risk and there will be other items that can be common across many industries where use in those other industries would be high risk. Electronic components is one of those areas where that clearly is a concern.

Thursday, September 8, 2011

Applying The Right Level Of Risk Management

You can’t expect the same level of risk mitigation in a $1 million deal as $100 million. For internally managed risks you probably couldn’t afford it and for transfer of the risk to Suppliers, they simply may not be willing to accept it. A Supplier’s agreement to accept risk is usually tied to the “rewards” they will see and the bigger the reward, the greater the risk they may be willing to accept. Risk management is something that needs to be managed with every purchase.You need ask yourself a number of simple questions about the risks involved to decide what may be appropriate; whether a contract is needed or Purchase Order may be used; and what should be included to transfer or manage those risks. Here are a number of questions that you might ask:

1. Is the nature of the purchase one time or is it repetitive? Many times a one-time purchase many not need an agreement as long as the nature of the purchase and the failure to perform are not high risk.

2. Is the nature of the purchase high risk? Could there be significant personal injury or property damage caused such as with chemicals, gasses, certain types of construction and things that are high risk on their own such as control systems for things like nuclear plants, aircraft controls, etc.? If there is you should probably have a contract.

3. Would the failure to perform be considered high risk? A high-risk activity would normally be one where the failure to perform would cause substantial cost or damages to the Buyer’s company. Another situation I would consider high risk would where the failure to perform would impact a senior executive in Buyer’s company and the risk is not so much about the impact to the company as it is the impact to the Buyer’s job and career.

4. If it’s repetitive, are you single sourced? Alternative sources reduce the risk, but don’t eliminate it. Frequently there can be a significant period of time for the alternative to respond. Alternative sources for purchases of products with long lead times will only provide long-term support but probably won’t provide any short-term protection.
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5. If it’s single sourced:
Are there alternatives that may be instituted at low cost? The greater the cost to change suppliers the less likely you will be to implement an alternative strategy.
Can an alternative be implemented quickly? For an alternative to have real value in mitigating the risk, you would need to be able to quickly get performance from the alternative Supplier to mitigate the impact of the other Supplier failing. For example if using another supplier would require a complete re-design of your product, that at best provides long-term protection against the risk.

6. Is there a significant impact if the price changes? Being able to have multiple qualified suppliers frequently requires splitting the business that can have a cost impact. If a product is marginally profitable, incurring that additional cost could impact that. Protection of the continuity of supply shouldn’t come at the cost of losing money on the product.

7. What impact would there be if the supplier failed to perform? This is probably the most important question in managing the risk. If the impact is small and more of an inconvenience, you need less protection and control than if there would be a major financial impact from the failure.

8. Is the purchase for internal use or as part of a sale to a customer? Where a purchase will be used also impacts the risk. If it will be part of a sale to a customer, in addition to any damages the Buyer would sustain from failing to meet their sales obligation, you also incur customer satisfaction issues that can damage the customer’s willingness to make future purchases from the Buyer. If the purchase is for internal use, the impact of the failure to perform will vary based upon where and how it will be used. For example, if it was a spare part for a piece of manufacturing equipment that was down it could impact production and revenue. If it was a service being purchased that didn’t have a revenue or major cost impact, it’s less of a risk.

9. Is the risk of non-performance significant? This is where you need to take a hard look at the Supplier you selected to determine what the likelihood of a problem is based on their past history of performance with you or the marketplace. The shakier the Supplier is for things that can impact performance like financial stability the more you need protections you need if they were not able to perform. That risk goes up dramatically if you are dependent on them such as being sole sourced with them or their technology.

10. Is the risk of litigation significant? There are two main types of litigation to be concerned about. One is a claim for intellectual property infringement. The other is a claim for personal injury or property damage. If the product that you are buying is a commodity that has frequent claims or there are any questions as to the source of the IP used, you need to protect against that risk. For personal injury you need to ask whether either the nature of the product or service is inherently dangerous where there are frequent personal injury claims.

11. If the purchase is for resale to a customer, did you select the supplier? Was the supplier or product specified by the customer? The reason why you would ask this is if the customer specified it, you should work with sales for what I would consider to be a form of “flow back” provision where you are only liable to the customer to the extent you can recover from the Supplier they specified. That way you aren’t assuming risk that you haven’t been able to cover with their specified supplier.

12. Are there specific customer flow-down requirements that must be met? If you are unable to effectively cover risks that apply to a customer flow down requirement with a Supplier, you should work with sales to either treat the specific supplier as an exception or the pricing given to the customer would need to include contingencies to cover the risk.

13. Is a specific license or grant required from the Supplier in connection with the Purchase? Any time there is a license or grant required, that will need to be addressed in the agreement. The only exception to this would be if you were purchasing break the seal software where the break the seal license will work.

14. What if the supplier didn’t ship the items, the items didn’t work, or there are quality problems with the product or service For all of these consider the revenue/potential financial impact of the problem and whether it’s a one time impact or there will be on-going impacts. The more you could have on-going impact the more you need a contract to drive the supplier’s behavior and recover some of the cost there performance problems created. You also need tools included in the contract to help manage and mitigate the potential risk.

15. Have you done business with this Supplier without a contract? As they say in ads for financial investments, past performance is not an indicator of the future. Before you decide to operate without a contract its important to think about whether there have been any significant changes to the Supplier that could impact performance such as changes to their management team, negative changes to their financial results, changes in ownership or location where the work will be done.

16. Have you had any problems? Have they responded quickly and reasonably when there have been problems? Before relying upon past performance you need to look for changes that could impact their responsiveness. If you’ve had problems and they have not responded as your would like, your award of any business to them should be conditioned on changing that with inclusion of terms that will help drive the desired behavior.

17. If you were able to contractually transfer the risk, do they have the assets or resources to stand behind the commitments? Contract commitments are only as good as the assets and resources of the company that is making the commitments. If they don’t have that, you need to have the tools you need to manage the risk and place less reliance on any financial recovery that may not be forthcoming.

18. Would you be better off having no agreement rather than accept the terms as proposed? If getting an agreement would require that you agree to severely limit your potential for recovery through a limitation on the types of damages that may be claimed or a limitation on the total amount of any recovery, if may be better to not have that agreement and work off purchase orders where the parties responsibilities will come down to the battle of the forms between the terms on Buyer’s purchase order and Supplier’s acceptance or confirmation.

19, Are they risks the Supplier can manage? The simple fact is that if there is a risk that a Supplier can’t manage, all that will do is drive the supplier to include a worse case contingency in their pricing to help manage the risk to them. If the risk never materializes, you paid the cost and they made the additional profit. It may be better for the Buyer to assume the risk and avoid paying the premium where if the risk materializes the savings would pay for the cost and if it doesn’t you save that amount.

20. Are there other steps you can take to help manage the risk? If something is really a risk you should have some form of contingency plan to help manage it that could include things like second sourcing, or inventory stocking.

21. If you were to assume some or all of the risk, are there controls or tools you need in the agreement to help manage the risk. Most standard templates are written under the assumption that the purchases are average risk and the supplier you are buying from is average risk. If you dealing with any higher risk purchases or suppliers you need a contract that has additional controls and tools to help manage the risks.

22. If the item being purchased is for sale to a customer, what are the real risks? The real risks are based not on the purchase terms but on the terms that you sell to the customer under. In most companies there is a significant difference in the terms they want to purchase under versus the terms that they sell under. The real risk to the company is not based on the purchase terms, its based on the sales terms.

23. Where Suppliers are unwilling to accept the contractual transfer of certain risks, and you must still use that Supplier you need your contract to include more controls to help you manage the risks you have assumed. Suppliers like to have significant freedom with respect to their actions and operations. That freedom can create increased risks for the Buyer. If they want freedom they need to accept the risks of their actions. If they are unwilling to accept the risks, you cannot give them the freedom and you need the controls to help you manage the risks.

24. If there is a problem, to what extent would a Contract provide you with greater recovery or protection than just a Purchase Order with a signed acknowledgement or confirmation? Contracts may not always provide more protections, especially if their terms include limitations on the types of damages that may be claim or limitations on the amount of recovery.

25. For international purchases you should always be concerned with the locations where operations will be performed. How stable is the country politically or economically? Instability of countries may impact the Suppliers ability to perform and stability of currency will have an impact on their cost structure.

26. How a company manages their labor, the programs they have for the health, and safety of their employees or how they manage their business from an environmental perspective may not create a performance risk. However they
do represent a potential political or image risk to the buyer. Companies spend millions of dollars managing their image and brands and don’t want those negatively impacted by the suppliers they use.

Tuesday, September 6, 2011

Educating the Supplier

A frequent cause of conflicts between the buyer and supplier is because the two companies simply aren’t compatible or there is a disconnect between between the companies. A Buyer does pre-qualification of suppliers to understand more about the supplier and their capabilities. A step that is frequently missing is the buyer educating the supplier on what doing business with the buyer will be like. That includes sharing with them your hot buttons and explaining to the supplier what you can do or can’t do with respect to other groups such as accounts payable, royalty payment administration. It may also include disclosing some of the internal processes that you must follow that will impact them or that they may need to follow or interface with.

Many years ago when I managed construction procurement for a computer company we hired a number of architect / engineering firms to design the facilities and manage the construction. Those firms were usually local to the area as we wanted them to be knowledgeable of the ins and outs of doing construction in that location. Every potential client to these firms is different. Some clients would give the firm complete control over the design. Companies like developers might strictly focus on cost and not care about operating costs as those would be passed on to the tenants. Our company was different from those because we had our own architects and engineers for every discipline on staff. We had program managers that were also engineers to manage the design and construction of the building and to interface with the internal client. So in interviews I would explain to the design firm that we knew what we wanted as we had built a large number of buildings in the past. We had a staff that would be actively involved in the design from all aspects. The CEO of the company who we referred to as the Chief Architect had clear preferences in terms of the types of designs and materials he liked and our architects would clearly manage to those preferences. We had engineers that had specific preferences for building systems and materials. We also had developed clear design standards that we wanted our buildings designed and constructed to. We also negotiated fixed fee contracts because we didn’t want them to get less of a fee if they helps save us money and we also didn’t want them to over-design or over-specify the design so they could make a larger fee. I also would explain to them our approach to managing construction was different from other companies. Instead of relying on the firm, we would have a manager on site, hire independent firms for inspection and testing of certain things and our Project Manager would manage and control the activity. The goal of all that activity was to try to avoid compatibility problems.

At the end of the discussion it would usually be very clear whether that approach and type of relationship would work for them or would be a problem. If you take the time to do that you will quickly see suppliers that may have a problem with it that could create conflict and not consider them. For the supplier that you do select telling them what they can expect up front helps eliminate complaints and conflict during the program. They were told in advance what they can and should expect.

As I was writing this blog I could an excellent example of a disconnect in progress. My wife was talking with a supplier where both parties were obviously upset. Her supplier was unhappy because they hadn’t been paid. My wife was upset because the company that she works for does not accrue purchase orders for payment. If a payment against an order to be completed in one quarter isn’t paid, that funding is lost. That means the payment would need to be paid out of the next quarter’s budget, reducing the amount of the budget. The disconnect and problem arose because the company’s practice requires separate tax invoices.The supplier submitted an invoice that included the taxes. Since they require separate invoices and since the invoice amount with taxes was in excess of the Purchase Order amount, the invoice wasn’t paid. The problems could have been eliminated if the buyer educated the supplier on its invoicing requirements and made sure that the suppliers people who generate the invoices knew the requirements. It was on the P.O. but sometimes that's not enough.

Friday, September 2, 2011

Getting Competitive Pricing When You Are Locked Into A Supplier

There are a number of ways that you can be locked into a supplier. They may be the only source for the item. They may have been designed into a product or service where it would be difficult or costly to change them. You may have voluntarily locked yourself in by giving the supplier a firm purchase commitment or a commitment to provide them with all or a percentage of your requirements. Since competition is the best weapon to managing pricing you want to avoid being locked in but there will always be times when you can’t avoid it. How do you manage those situations?

If you make firm purchase commitment or requirements commitment both of those types of commitments should be conditioned upon a number of factors. You want the assurances that the Supplier will remain competitive over the entire term of the commitment. Competitiveness means not just the price of the product or service you are purchasing, but the technology of the product being competitive in the market. Competitiveness also applies to the terms they agree upon and the Supplier’s performance for quality, delivery and the overall cost of doing business with the Supplier. That’s because not all cost involved in the relationship is included in the price. You also want relief from those commitments for situations when the supplier can’t meet your demand, doesn’t perform, or is unable to perform such as in force majeure situations. For the price aspect before you get locked into a supplier you should include a benchmarking provision in your agreement. Agree upon how benchmarking will be done and have language in your agreement that they must either adjust their price to the benchmark price or you have the right to cancel the firm aspect of the commitment without liability.

If you haven't made a firm commitment on volume or on requirements, the issue is always the trade off between any price premium you have versus what it will cost to change suppliers. If you go to a supplier strictly for benchmarking purposes you should tell them that. In that case you use benchmarking to highlight the cost difference from several perspectives. You can use the price differential to show how that will make it easier for you to consider alternatives as the cost of switching will be paid for by the savings. Many times a supplier will be happy to provide a benchmark price as they will see that as a sign that you are unhappy with the pricing you are getting from your current supplier and see that as a potential for future business. With the incumbent supplier you can also discuss how the cost difference will impact your future sourcing decisions if nothing is changed. In both cases the supplier will get the message. Whether they will respond to that message and offer more competitive pricing will depend upon what the impact of loss of your business will mean to them.

If you use the benchmark suppliers for other items and you have a good relationship with them or the they think they have a reasonable chance of getting business in the future the data won't be exact, but it will be relevant. If they don't think they may get business in the future they probably won't respond or would want to get paid for the activity. In that instance it would be better to hire an expert to provide you with benchmark data.

A supplier can also benchmark by using cost models. There are Bottom-up Models, Top-down models, Algorithm based models, Predicted cost estimates, Comparison models/ Analogy models and Parameter cost models. Most of those require a detailed knowledge of the product or service and the costs. Benchmarking falls into the comparison/analogy type of model. Its the easiest to do if you don't have the knowledge of the product or service and its costs. If you don't have that knowledge and don't want to benchmark, you would probably need to hire an industry expert to provide you that type of data.

Many of the concerns with using other suppliers to provide benchmark data can be managed to make them legitimate. One is to not use any of the losing bidders as part of the benchmark so there is no bias. If you are forced to include one of the prior bidders in the benchmark activity and you have three or more benchmark suppliers I've used the approach that we throw out the low bid and create the benchmark based upon the average of the remaining quotes just so the supplier would agree to a benchmark as that would eliminate the bias issue. I've also gone to other suppliers and have paid them to provide a detailed cost estimate as a form of benchmark.

I’ve been locked into suppliers by designs and have then worked with engineering to identify and qualify alternatives. That’s the primary option you have if the supplier doesn’t respond to your messages and continually abuses their position. When the orders to them stop many are shocked and will ask how they can get the business back. My response, which is always tempered based upon other business that we may have with the supplier as either a supplier for other items or as customer, will vary. If the two solutions are not directly interchangeable, I would tell them that the business is gone as I’m not going to get locked into them again as a single source and that I can’t afford to manage two different solutions. If I need them and the solutions are interchangeable I may tell them that they need to not just match the competitors price but offer a better price so they effectively pay for the cost they drove by their behavior. They forced me to invest in developing an alternative. If I don’t need them and we don’t have any customer relationships I probably would tell them that if we need them we’ll call them. A good sales person will listen to the messages their customer gives them and will respond before it gets to that point.


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