Okay, Week 3, Contract Management. Now you've selected a supplier, you're going to have to determine a contract to issue them. And you might say, well, all contracts are the same. Well, they're not and we're going to show you different types of contracts here. So first what I want to do is just walk you through the two major types and then we'll cover them a little more in detail for each one. So a firm fixed contract is exactly what it says. It says, it's a fixed price. There are some additional types of contracts. We have one with escalation and one with incentives. I'll go through each one of those. And then cost-based have a similar type of contracts and you don't use these quite as frequently as the fixed base contracts. But again, we'll talk about the cost-based with incentive, time and materials, and then cost plus fixed fee. And I'll try to give you some examples as we go through it. Firm fixed price is you're going to probably use something like this probably 85, 90% of the time. It's probably what most procurement people do. Basically you've gotten a price, you've selected a supplier, and you've determined that you're going to just issue a contract. It's the simplest and easiest type of contract, majority of purchase orders that are issued by procurement as I said, probably 85, 90% are in this particular area. And I think what you need to know about firm fixed price contracts is the supplier bears the risk. If the underlying commodity goes up, it's fixed. And you say well, that's great because I don't have to pay for it. But flip it. If the underlying commodity's going down basically, you're not going to get any benefit. So that's the reason you have some alternative to the straight-up fixed price contract. And more importantly is that if a supplier knows that if he's a rising market he could put a contingency price in there. Which you may want to have because of the market doesn't go up you're going to pay for it. So before you pick something like this, make sure you think about what's the underlying commodity? So as an example would be if it's a straight-up MRO type item, maintenance repair and operations, very straightforward. A firm price is probably fine. If its underlying commodity such as transformers that have copper in them, you may want to think about is that what you want to do in this case because copper is a very valuable commodity. And we'll show you some other alternatives that you can use other than just having a firm fixed price contract. So one of them is fixed price with an escalator. So let's take an example so you understand. In general, this is for a little longer term contract, you have a relationship with a supplier. And let's say corrugated boxes. So corrugated boxes, the paper that makes up corrugated boxes is called liner board. And there's a market for liner board, you can look it up. It's a there's a London market, you could even look it up. And it's very volatile, it goes up and down. So what a supplier would do in this case, and you would say look, I will give you a contract for year and then if the underlying commodity goes up or down we're going to review that and adjust prices to some predetermined formula. All right, so it's very straightforward. There's no negotiation. You say if the price is, in this particular example, liner board's about 65% of a corrugated box. So you know that, and if the price goes up by 10%, 65% of the price would go up if you follow my logic. So in any case, it's one way to do it and if the price doesn't move, it just stays fixed. At least the other portion of the non commodity is fixed for sure. So that's one plus of having this type of arrangement. You can have a fixed-price with incentives. So this would be something you say, look, we gotta fixed price, but let's you and I work together and have some sort of a cost sharing plan that we come up with ideas, we can reduce costs together. And it's pretty good for very high unit volume where maybe the two of you can work together to to reduce costs over time. The question always comes up in these types of profit sharing type of thing or cost sharing is that who gets the price on the next go around. So that's something you can think about. But be it as it may, it's a good way to do it. If it's a very high volume and it's something that you two can work together to reduce cost. We mentioned cost-based contracts, you're going to use these a lot less often than the fixed base contract. But if there's a very high risk, the supplier contingency fee is very high and you really don't know a lot of details, and you want to try to lower that risk for the supplier. You could have a cost-based contract, this would be particularly helpful if you have open book costing. And then what we can do together is you may get a lower price long-term. You'll have to have very good terms and conditions in what you're going to monitor or not monitor. People are going to have to agree what's allowable, not allowable. But it's particularly good when goods and services are pretty expensive and complex and there's a high degree of uncertainty by both parties not knowing what's going on. So it's another way to, particularly if you trust the supplier, it's another way to get at it and work together so you understand what their costs are. Particularly when you don't know what going into the initial contract. Much like the fixed-price contract you can have incentives. You could say, let's have a cost plus incentive, where again, you work together on cost savings and you'll be able to share those cost savings. So it's the same idea. The time and materials, so this is one where you really don't know the specificity of what you're buying and I'll try to give you an example. So you go to supplier, and this is true when I was working in Mars Tennessee plant. It's a brand-new, it's an old plant, people really don't have good drawings. They don't know what's behind the wall, you're telling the supplier to take the wall down. He has no idea what's behind that wall. And you don't have drawings to help him. So he says I'll do it. But let's do it on time of year basis because if I had problems I'm going to have to understand. Now, what I can do for you is give you a cost not to exceed. So I can say, I'll do this job for $20,000. I know it's not going to be more than that. But we together, along with engineering, are monitoring this whole process as you're taking the wall down. So it's a way to get control when you really don't know what you're buying so to speak. Cross plus fixed fees, another one where you have a cost and you just have a potential fixed fees. This can be very good. But in one of the downsides of this one, there's little motivation to control cost. So we use this, a modified version of this type of contract, when I was at Mars in the warehousing area. So we'd say to people, it's we'll have cost plus a set fee or set percentage, so much dollars or percentages, it's fixed. And then we said, but we're going to have the ability to monitor cost. So what we would do in the initial years is we would look at the cost comparing against one versus the other. And if we could reduce the cost, we would do so and reduce the overall warehousing fee. We took it a step further in Mars. And we said because at one time they're not compete suppliers just about all of them, we would get them in a room and compare everybody's cost. Everybody would learn, but the beauty for us is we could lower overall cost. They still got their fixed fee, whatever that percentage was or that dollar amount was. But it would at least it was a way of getting at something that's highly variable. So that's cost plus fixed-fee. So as you can see in this chart, you can come back and look at it later, that there is these types of six contracts where the buyer's risk can be low to high and supplier risk from high to low. So you have to determine what's the right contract for you? Now, it's possible that your legal department handles the terms and conditions on the back of the purchase order for you because generally there you know what those are we talked briefly about that. Where basically you have your terms and conditions on the back the supplier has to do. But this is the type of contract we're talking about here, not the terms and conditions. So it's very important to be able to think about what are the risks and to whom when you issue the contract. Let's move on to contract length, right? So a spot contract would be something you're buying a one-off type of thing, a bunch of let's say, awards for the employee of the month. You can do a one-off, it's a spot contract you would issue a fixed price contract. You can have a short-term contract. Generally, this is less than a year, pretty routine items you put in contracts I mentioned for things like potentially office supplies or maintenance and operating items, whatever you think could be longer. And then lastly, there's the longer term contracts. Many times these can be evergreen contracts, much like the fragrance and flavors we talked about, generally more than one year. Now, I have to tell you that a friend of mine I was talking to one time, a guy named Tom Lennon from CPU of Intel, and he said to me I've never found a five-year contract, I'd like to. And what he meant by that, five years is a long time for contracts. And I certainly don't encourage you to go five years, but certainly you could do multiple years or at least have some sort of evergreen process if you're going to go more than a year. So a lot of things can happen. So that's the type of contracts you need to think about. So let me throw out another question here if I could. Which is better, a long-term contract or a short-term contract? Give you about 30 seconds to think about. Okay, so I think you already know the answer to this, it's kind of a trick question, it depends. It depends, there are pluses and minuses. So let me just briefly walk you through the benefits of a long-term contract. Obviously, the converse would be true with short-term contracts. So certainly if you want to have assurance of supply, particularly if it's a tight item and tight market, we were talking about electronics having a very tight capacities. They're going to want to have a long-term contract in place, Intel chips for example to make sure that they can get those Intel chips for five-year periods or whatever, right? You want to make sure that you have access, as I said earlier for these strategic items if you can so we talked about having. Should be costings or open book costings, you want to make sure you have it. Maybe you need the technology. You're working with the supplier, he's going to make an investment in technology and you need that technology, so a long-term contract. Certainly volume leveraging is important. The supplier wants to be able to book his plant over a long period of time and you can get the lowest possible price. So all these things are important for the benefits of a long-term contract, but there are risks. And this is something you need to think about. Supplier could take advantage of you. Basically, you get into this contract, it gets difficult to get out. He may be able to take advantage of you in the contract. Maybe you find out you selected the wrong supplier and it's very difficult to get out of this contract the way it's written. What happens if the supplier's volume decreases dramatically? You said you're going to use a 100,000 units a year, it's only 2, that could be a problem, right? Supplier forgoes other businesses. So he's going to give you the contract but basically the risk is that he potentially is forgoing other business, it's going to hurt him quite a bit if it doesn't work out. And sometimes the buyer himself can be unreasonable. We have this five-year contract, you must do the following things for. So these are all risk and you can work around the risks and opportunities for short-term contracts in really just the reverse. So let's do a wrap up here. So it's procurement's job after you've selected the supplier determine the type of contract should be used. And you need to understand what the advantages and disadvantages are of short and long-term contracts, which I think we covered here. So that's it for week three. Look forward to seeing you in risk management for the next two weeks.
