A common example of this situation is where you have a project that will run for 12 months or more. Throughout the project you know there will be times when technical support, due diligence and specialist knowledge will be required, but exactly when and how much is impossible to define at the outset of the project. At the same time, retaining the same provider for the duration of the project is equally important.It is not uncommon to see broad specifications and “big bucket purchase orders” used in these situations, often tied to time and materials agreements. Sure you lock in the supplier and give the project the flexibility they need to engage the vendor as required, but have you achieved the optimal outcome?A key issue with this model is that it is generally very difficult to demonstrate any benefit has been gained by having the vendor engaged. There are no documented deliverables or milestones to provide a yard stick for progress. So not only is is difficult to demonstrate the good news of achievement, it is also very difficult to hold the vendor accountable for poor performance. The authorised person who is accountable for ensuring it is a good engagement would honestly have some difficulty in explaining the grounds for that decision.
When the contract is established, a table of rates may have been included. If a good process was run, then market tension should have provided a degree of discounting against the list price, but has the pricing point been optimised? If your organisation has a reputation for always negotiating, always requesting a BAFO, then the vendors will have come in high any way. Even if they haven’t, the key to getting the best prices is certainty. If a vendor knows the level if work they will get, they can more effectively calculate costs and overheads and then pair down the best price. Without certainty, they have to pad the price to allow for the unplanned costs or the need to cover overheads over a shorter period.
So what we need to do is provide a structure that will allow us to give the vendors a degree of certainty when they are developing their offer, and then provide functionality that will enable certainty for the business through the project.
Certainty for the offerors
What certainty do the offerors need to be able to provide an optimised price? More often than not, it can be broken down to the simple term of volume. Volume buys allow the vendor to spread overhead cost. In some cases overheads can be reduced, for example, with goods, bulk buys remove the need to split packs and repackage, allow optimised manufacturing runs, reduce the number of picks and can allow reduced or discounted shipping costs. In the case of services, overheads are calculated as a projected percentage of under utilisation, the cost of administering the resources and the costs associated with responding to opportunities. Most service related costs are variable and therefore open to optimisation.
It stands to reason then that if we can give the vendors some certainty around what the volumes and percentage of utilisation will be, then they can adjust their calculations accordingly and thus provide their best price. For short term engagements or well defined projects, then this is achievable through detailed requirements definitions of the work to be carried out and the time frames. Where the work is over a longer period of time and/or the type of work is dependent on the outcomes of other stages of projects, then this is not possible.
In the case of buying goods, demand is often market driven and often highly variable. To address this variability, it is very common to offer volume break points and rebates as both an incentive to get customers to buy more, and to provide some certainty around the price to pay when there is no certainty up front around volumes.
This same concept can be utilised in buying services. As illustrated earlier, consultants and service related industries have variable costs associated with them based on different parametres. Even so, many of the variable overheads are reduced or dispersed though increased volume, or utilisation. The price breakpoints model can be implemented just as effectively in these procurements as they are in sourcing goods. In many cases, the vendors may not have even considered the concept of volume discounts themselves, so it may be necessary to specify a framework in the invitation documents and/or be prepared to negotiate this point. The aim is to identify the drivers of costs and get the vendor to identify what conditions will result in a reduction in overheads, or the ability to spread the overheads more thinly.
Examples of the kinds of break point parametres you may see are:
- exceed 30 hrs utilisation per week for 4 consecutive weeks
- Greater than 90hrs utilisation per month
- Spend threshold of $50,000
Lump sums and retainers
This is the big bucket purchase order territory. To overcome the uncertainty, the project will give themselves freedom to engage the resources as required either in the form of a fixed monthly retainer payment or simply a pool of money to be drawn on as required as time and materials. These models are very difficult to control, often resulting in the project being uncertain of exactly what they had delivered and just as often, varying the contract to add funds to pay for work completed that exceeded the value of the contract. Because they are difficult to track, they are also prone to overspend and scope creep.Further to that, the prices offered by the vendor are often less than optimal. The retainer method is one method some vendors will use to get some certainty, and as a carrot they will indicate that they will discount their hourly rates to say thanks for the cash. But if you can’t control the “level” of the resources used or the hours they work, let alone enforce the delivery of expectations, the discounted rates offer little value. By “level”, I refer to the level of experience of the resources provided. It is not unusual for a senior consultant to be provided when a junior could have completed the work. This of course increases the margin gained by the vendor and consumes the available funds more quickly, therefore reducing the effort required by the vendor while putting the organisation in the position of still needing to deliver the project and being committed to the vendor through reliance on the Intellectual Property developed through the engagement. Conversely, where the vendor is on a monthly retainer, the incentive for the vendor is to provide resources of a lower level and to work them less hours as they will get the same payment each month any way. The retainer becomes a reliable source of income while they chase other contracts and assign key resources to more effectively managed contracts.If you must implement this model, and there a very few situation when it is a viable solution, make sure two things are included in the contract:
- The contractor is not to undertake any work without written direction and approval from an appropriate authority
- The contractor must not issue any invoices until they have provided a report including time sheets and details of deliverables or milestones completed and the business has confirmed that value has been provided
Scoping the work
This is the real challenge, if the deliverables are dependent on the outcome of other activities, how do you scope the work accurately enough to allow the vendor sufficient certainty to calculate their best price? The answer is that you can’t. Instead, you need to implement a contractual framework the enables a method of defining, quoting, negotiating and agreeing a package of work to be delivered efficiently through the life of the engagement. This falls into a Standing Offer Arrangement (SOA) or a work order format contract. Each of these function in much the same way, an agreement is established that defines the core agreement between the parties, insurances, terms and conditions, our break point pricing and discount model discussed earlier, and the full scope of possible services and goods to be provided through the life of the agreement. This part of the contract allows us to lock in the company we want to retain for the duration of the project, but there is no commitment to spend at this stage. Note also that this should be aimed at engaging only one company, if you introduce multiple vendors on the SOA, then the certainty for vendors has been reduced as they will now get an uncertain share of the work, and the pricing will reflect this.
The child contract under the SOA, or the work order under a contract, is the mechanism for establishing the certainty and commitment on both sides. In your parent agreement, you should clearly define the process to be undertaken to establish one of these child contracts, who has authority to bind the agreement and also make it very clear that no work is to be undertaken without a signed child contract. The child contracts must only be established when the work required is able to be clearly defined and the vendor can provide a solid fixed price. Under these circumstances, only two parameters need to be managed by the business; the level of the resources; and the number of hours proposed. In the early stages this can be challenging, but over time, good contract management will allow the organisation to develop an understanding of who should be working on particular tasks and how many hours is reasonable.
In general supply chain speak, this is a form of delayed differentiation. The initial framework is established in advance, but the final definition of the work is left to the latest possible moment. This prevents waste, enables agility and will result in a far more effective relationship between the customer and the vendor. Deliverables, resourcing, cost and performance expectations can be more accurately defined, delivered and tracked ensuring the vendor is confident in their expectations and can be managed far more effectively. This method also enables payments to be attached to deliverables again to ensure there is a solid correlation between expenditure and delivery, and an incentive for the vendor to deliver on time and to standard.
Conclusion
So clearly, the aim in uncertain situations is to find a method of building certainty into the agreement between the vendor and your organisation. In many cases this requires an approach that provides multiple levels of certainty, and here is another example where you need to go one step further. An organisation required external suppliers to provide technical services to a major programme of work. Within that programme of work, the technical services would be required to deliver discrete packages of work, but then on occasion they would be required to deliver projects over several months with deliverables dependent on the outcome of other projects. The programme of work spanned many years, at times the work load would be very high and exceed the capacity of one or two vendors and there was a very wide scope of requirements, it was also critical to retain the same vendor on those projects. So it was meaningless to establish a fixed price contract and even a retainer or time and materials model would fail to ensure the requirements would be effectively met. This would need to be a competitive panel that the vendors bid for work each time so that each had an incentive to be on the panel and to offer the best possible value proposition for each requirement. The outcome was an SOA established with four vendors, and as a component of the SOA, there were two child contract templates. One for engaging specific packages of work in the traditional form of an SOA, the other allowed the engagement of a vendor on a project and then the issuing of work orders as required.
The value of this structure was that a large market was reduced to a smaller group of pre-qualified and committed suppliers who new that they had a fair shot at winning a solid share of the programme of work. The competitive tension was retained for the development and awarding of each package of work, plus an extra level of framework and control was offered through the ability to select one vendor to deliver a project consisting of multiple packaged of work.
When the business has an unusual requirement, don’t expect a simple and traditional solution to work. Consider the real needs, the drivers that will determine if a vendor will offer their best price, then develop a solution that will take all of these aspects into consideration.