Tuesday, November 30, 2010

Rewards As An Alternative To Penalties In Contracts

I hope that you enjoyed the article "Tips For Negotiating With A Sole Source." I wanted to use this post to expand upon one of the items from the article, specifically "Create tiered risk/rewards scenarios for Service Level Agreements."

Obviously, with any contractual relationship, you want the supplier to perform well. A traditional way of "forcing" the supplier to perform well is penalizing the supplier for poor performance. This often takes the form of a liquidated damages provision that requires a supplier to pay your organization a predetermined amount in the event that it fails to meet a contractual obligation. (Note: if you want to learn more about how to write liquidated damages or other contract terms, consider enrolling in our online class "Supply Management Contract Writing.")

While the threat of having to pay does scare some suppliers into good performance, liquidated damages or, informally, "penalty" clauses:

  • Are tough to get suppliers to agree to;
  • Often don't get consistently enforced by buying organizations and, therefore, can end up being considered legally waived; and
  • Can hurt a supplier relationship when mistakes are punished.

An alternative is that "risk/reward" scenario described in the article. Let's walk through an example.

Let's say that a large grocery chain sends its broken cash registers to a supplier to repair. The supplier has proposed a price of $99 per repair and will not budge when the grocery chain attempts to negotiate. The supplier will also not agree to the grocery chain's demands for a liquidated damages provision that would require the supplier to pay $20 per day for each day that the supplier takes to complete a repair beyond the five-day requirement. Being without a sufficient number of cash registers harms the grocery chain's operations, so they have a vested interest in getting repairs completed as soon as possible.

An example of a scenario that the grocery chain could propose that would give the grocery chain the assurance of good performance and may also lead to even better revenue for the supplier (which the grocery chain would be pleased to fund) is as follows:

  • The price per repair would be $97
  • For repairs that are completed in three days or less, the supplier would be able to bill at $101

Compared to the original arrangement, the grocery chain got two things it wanted: a lower price and a lever that will compel the supplier to want to perform. The supplier got an opportunity to earn even more revenue than it proposed if it is able to perform better. Obviously, if the supplier feels it can easily increase its repair time, this would be attractive.

Now, this scenario may not be the one that gets accepted. Some additional negotiation may need to occur so that both parties are satisfied. But it shows a way to tie performance into price which, in some cases, may be the only way to successfully reduce prices and get better performance out of a sole source supplier.

To Your Career,
Charles Dominick, SPSM
President & Chief Procurement Officer
Next Level Purchasing, Inc.
Struggling To Have A Rewarding Purchasing Career?
Earn Your SPSM® Certification Online At
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