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Ready, set... Outsource! Which logistics cost model is best for you?
Mark Borkowski
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. In many organizations, the responsibility to outsource has fallen into the domain of the purchasing department.
Since many traditional middle managers overseeing the procurement of transportation services aren’t skilled in the art of detailed negotiations and financial analysis, this function has progressively been moved into purchasing. So what should purchasing people know about this complex area? And why outsource in the first place?
According to Steven Trumper, a partner at business law firm Osler, Hoskin & Harcourt, outsourcing offers significant potential advantages to the customer. Some of the key attractions include:
• Reduced capital investment in real property, capital equipment and information technology infrastructure;
• Access to specialized “best-in-class” expertise and new technology (such as RFID);
• Better visibility for the customer on supply chain costs;
• Opportunities for process improvement and better risk management (such as labour disruption).
One of the key challenges in completing a third party outsourcing arrangement is negotiating the pricing arrangements. There are generally two pricing models in the supply chain context:
1). Base fee plus unit pricing
In the first model, 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 aren’t achieved, the customer must compensate the supplier. According to Trumper, “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.”
2). Cost-plus transactions
An alternative pricing model for supply chain outsourcing is the “costplus” transaction. In this approach, the service provider is compensated for its costs plus an agreed upon percentage margin (sometimes capped at a total dollar amount).
The advantage for the customer is it has full visibility of the supplier’s costs and profit. The challenges to implementing this model include:
• Agreeing on the yearly budget and productivity measures;
• Encouraging the supplier to reduce costs (such as through gain sharing);
• Allocating shared costs (supplier IT platform) between customer and supplier where many customers may share the same supplier infrastructure.
Termination rights are another important financial issue in supply chain outsourcing. More customers are demanding maximum flexibility in their supplier relationships, and in particular, the right to terminate supplier contracts on short notice.
Since supply chain outsourcing may require significant long-term investment by the supplier, in real estate and IT systems, early termination will expose the supplier to substantial financial losses.
To mitigate this risk, suppliers will often require the customer to compensate it for unamortized capital costs if the customer wants an early termination right. Customers should ensure they understand the nature of these costs before agreeing to the approach.
Trumper believes “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 longterm relationship, both the customer and service provider have a vested interest in ensuring the chosen pricing model provides appropriate financial benefits to both parties. b2b
Mark Borkowski is president of Torontobased Mercantile Mergers & Acquisitions Corporation, a mid-market mergers and acquisitions brokerage firm. He can be contacted at (416) 368-8466 ext. 232 or mark@mercantilema.com
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