Thursday, May 10, 2012

Cost-Plus or Fixed-Price – What’s the Best Type of Contract to Promote Productivity and Reduce Costs?

At the North America Parts Benchmark (NAPB) this year, we gathered a group of motor vehicle OEM subject matter experts to discuss how they use and manage third party logistics (3PL) providers for warehouse operations, transportation and other activities. While we talked about 3PLs in general, we did not discuss any 3PL in particular.

One of the main topics covered was on the contract type, should we be using cost-plus or fixed-price contracts?

Cost-plus contracts require the OEM to pay for the 3PL’s costs, plus a fee for profit. This type of contract has several advantages:
  • It can result in a lower price than expected for the OEM, as there is less risk for the 3PL in accurately predicting their costs.
  • The contract can easily be scaled in the case of future expansion.
But there are also disadvantages to cost-plus pricing:
  • The 3PL has less incentive to reduce costs, as they are being reimbursed for them anyway.
  • There is little need to improve efficiency, productivity, and quality.
  • If the 3PL does not adjust the labor force as needed, you may be paying for excess labor.
Fixed-price contracts are often on a price-per-line basis, whereby the 3PL is paid for each line shipped from and received at the warehouse. This offers a different set of advantages:
  • The OEM can predict their costs based on the volumes expected.
  • The cost can easily be passed to the customer in the form of a handling fee.
  • The 3PL is encouraged to be more productive, as they can bring in more money per hour if they ship more lines.
Disadvantages to fixed-price contracts include:
  • 3PLs may under-bid to secure the contract and then are unable to perform.
  • The 3PL has little incentive to reduce costs for the OEM, but has a large incentive to reduce their internal costs, sometimes to the extent where quality suffers.
  • There can be difficulty with scalability; large increases in volume could result in much higher costs to the OEM.
There is a mix of contract types used by the OEMs in attendance, with no clear trend as to where the industry is moving. Some companies shared that they are moving from a cost-plus model to a fixed-price model, and others are moving in the opposite direction.
Satisfaction was similar across contract models, with a slight advantage to cost-plus in the small sample of companies surveyed.
Bottom Line: About two-thirds of the OEMs we talked with do not use bonuses or penalties to encourage the 3PLs to achieve performance targets. OEMs need to think hard about how best to implement performance-based incentives as part of either type of contract to minimize costs and maximize productivity, quality, and overall service level.

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