M & A Matters: August 2014

More and more companies, large and small, are outsourcing all or part of their supply chain functions. In today’s competitive economy, the constant need to improve productivity and do things faster, cheaper and better has created a growing market for specialist providers of third-party logistics services. Some of the key attractions of logistics services include reduced capital investment in real property, capital equipment and information technology infrastructure. Good logistics providers offer specialized expertise and new technology, for instance, RFID tracking. When you get invoices for logistics services, you can give your customers more transparency on supply chain costs. Logistics specialists may find opportunities for process improvement, and using a third-party supplier provides better risk management for you (no down time when a driver calls in sick).

One of the key challenges for customers in completing a third-party outsourcing arrangement is negotiating the pricing arrangements. There are generally two pricing models in the supply-chain context. In the first model, base-fee-plus-unit pricing, the price charged by the service provider includes two components: a base fee (usually paid monthly) to cover fixed costs such as facility lease costs and capital equipment leases; and a variable fee (also usually paid monthly) to cover costs (such as labour) that flex with changes in product volume moving through the supply chain.

Another adaptation of this model is per-unit pricing with minimum volume guarantees. If the minimum volumes are not achieved, the customer must compensate the supplier. The key advantages of this price model are the ability to combine price certainty (for both customer and supplier) with the flexibility to adapt to changing market conditions. The disadvantage from the customer perspective is the lack of visibility on the supplier’s cost structure and profit margins.

An alternative pricing model for supply chain outsourcing is the cost-plus transaction. In this approach, the outsourcing service provider is compensated for its costs plus an agreed percentage margin (sometimes capped at a total dollar amount). The advantage for the customer in a cost-plus transaction is that it has full visibility on the supplier’s costs and profit. However, there are several challenges to implementing this model. Agreeing on the yearly budget and productivity measures is the first hurdle. You might be left scratching your head over how to encourage the supplier to reduce costs and thereby increase your share of the charges. Allocation of shared costs between the customer and the supplier, where many customers may share the same supplier infrastructure, can become a bone of contention.

Another important financial issue that frequently arises in supply-chain outsourcings involves termination rights. More and more customers are demanding maximum flexibility in their supplier relationships, and in particular the right to terminate supplier contracts on short notice. Since a supply-chain outsourcing may require significant long-term investment by the supplier (for real estate, IT systems etc.), there is a risk that early termination will expose the supplier to substantial financial losses. To mitigate this risk, suppliers will often require the customer to compensate them for unamortized capital costs if the customer wants an early termination right. Customers will want to ensure that they understand the nature of these costs before agreeing to this approach.

The outsourcing of supply chain functions offers many potential competitive advantages to customers. Pricing will generally be one of the most important considerations in making the decision to outsource, and there are different pricing models that may be appropriate depending on product profile, operational risks and the customer’s financial goals. Since outsourcing is ideally a long-term relationship, both customer and service provider have a vested interest in ensuring that the chosen pricing model provides appropriate financial benefits to both parties.