Integrated supply agreements

“The Destroyer” Mills vs. Hurtte

by Frank Hurtte and
Malcolm Mills

In this issue, Malcolm and Frank don the Spartan shields of battle and square off in another Hellenistic grudge match. Let the battle begin.

Frank’s sales perspective
Supply contracts in one form or another have been around for many years, but in the past 10 years, nearly every distributor in the nation has been affected by the integrated supply contract. Typically, these contracts are sold at the very upper reaches of “Mahogany Row.” A slick-talking suit from out of town approaches the VP of Acquisition with a plan to take 20 percent out of the cost of MRO materials. The system works great on paper, but the people who pay the bills see it differently. Usually, the conversation goes something like this: “I hate to tell you this, but we are going to buy our widgets from some national distributor. I don’t think it will work, but the boys at corporate have a gun to my head.”

Malcolm’s procurement perspective
OK, I’m game. Let’s discuss integrated supply contracts and systems contracts. Theoretically, these arrangements are supposed to be beneficial all around, to the supplier and to the customer. Forget the slick talkers, you and I have both been seduced by “Kaa” in business suits. (Look into my eyes, Frank).

Integrated supply, in very broad terms, translates into a chosen supplier effectively becoming a part of the customer procurement/production team and working together to mutual overall benefit. The agreement improves transaction-based efficiency for both the buyer and seller and everybody lives happily ever after (cough).

Procurement benefits should include:
• The buyer needs only transact with one company for whatever product(s) or service(s) as identified in the contract
• Fewer purchase orders, invoices and receiving transactions, resulting in reduced administrative workloads and fewer transactions
• Reduced stagnant/static inventory of maintenance, repair and operating (MRO) items
• Possession costs are reduced, company capital is freed up for other uses
• Product costs are reduced based on reducing the number of former suppliers, and new value-added services coming on stream bring benefits.

From the supplier/distributor perspective:
• Supplier gains a firm legal contract for the exclusive supply of certain goods and/or services for a set period
• The supplier/distributor becomes positioned to provide further technical and supply services for future contracts and engineering purchase requirements
• Outside sales costs are reduced
• Administrative workloads are reduced through improved flow of sales orders, invoices and receiving transactions
• Reduced acquisition costs due to larger or scheduled orders from manufacturer
•Reduced inventory costs due to lower inventory and JIT deliveries.

Frank’s sales perspective
Integrated supply, in theory, is probably a great thing. In instances where the procurement side comes to this solution in a true spirit of partnership, things work out well. As I see it, the problem in most applications lies in three areas:
1) Cost reduction is confused with price reduction
2) The buyer fails to live up to the initial premise of the contract
3) The long-term viability of the contract
Let’s address each of these in a point-by-point manner.

Cost reduction vs. price reduction
Frank
In integrated supply contracts I have seen, the contract was accompanied by a market basket of items to quote. And even though the distributor was told, “we are doing this to reduce transaction costs,” the customer still used the guy with the lowest price to beat down the price per item. Other times, the customer wanted the distributor to commit to a fixed margin – again, the margin percentage became a negotiating point. From where I sit, it looked a whole lot like a tool for driving down price.

Malcolm
Yes, traditionally buyers must use the lowest quote as a foundation for negotiation. What are your own buyers using, Frank? Customer buyers don’t have access to your numbers. They must assume that you have a comfortable profit built in or you wouldn’t be in business. They reason logically that if your competitor can quote the lower price, why can’t you? The supplier’s job is to justify and to prove to the buyer why they cannot meet the lower bidder’s price, convincingly demonstrating the added value they are providing, thus justifying your higher pricing (apples to apples).

Frank
In study after study, the real cost in MRO purchasing is found in transaction costs rather than distributor margin. Remove the roadblocks to seamless flow of materials and the costs go down rapidly. And, the distributor needs to stay in business.

Malcolm
Market basket items or otherwise, transaction costs are astronomical in manufacturer/distributor sectors for some of these reasons:
• Over and under shipments
• Shipping the wrong product
• Shipping out of schedule
• Failing to include documentation or incorrect documentation
• Shipping expired or nearly expired materials
• Shipping out-of-spec parts
This results in hundreds of additional transactions on both sides. These all drive up transaction costs. Your customer experiences the same problems, believe me. Unfortunately, many of these transaction costs are self-inflicted. Frank, I want you to make your margin, basket or no basket. I don’t want to pay for your screw ups.

The buyer fails to live up to the initial premise of the contract
Frank
Last week, I had coffee with a top executive from the distributor side of the integrated supply business. Our conversation turned to the exaggeration factor built into MRO supply contracts. I told him about one account I worked on a few years ago where the estimated MRO spend was $5 million. After three years, the largest spend I ever saw was 60 percent of this number. He told me he has seen contracts where transformer substations – the gigantic kind purchased once in the lifetime of a facility – were factored into the estimated MRO spend plan. Either someone had some bad data, or there was chicanery in the mix.

Typically, there are measures and penalties in place for the distributor. If you don’t produce estimated savings, you are penalized monetarily. The procurement side doesn’t live up to its agreement and walks away unscathed. We should explore ways to put safeguards into the equation.

Malcolm
In instances where there are penalties in place for the distributor for failing to deliver per the contract, why wouldn’t there be adequate measures in place for compensating the distributor if the customer fails to purchase a negotiated amount? You can’t believe this is the fault of the buyer. Sales reps are required to diligently negotiate contracts to their own advantage. How could anyone miss a substation? It could be both of their faults, but come on, that’s too sloppy. But that said, a fair buyer would open that back up for negotiation. Own up to a screw up and a buyer will generally open up.

And you’re saying it took them THREE YEARS to address this problem? Was someone asleep under a tree, or what?

Frank
Malcolm, now you have gotten into the Jimson weed again. Can you imagine a $15 million distributor going to the procurement department of a Fortune 500 company with a bill for not living up to their agreement? Even if they managed to get the bill to stick, can you imagine the level of retaliation they would face?

The long-term viability of the contract
Frank
Far too many procurement experts see the cost savings of integrated supply as a continuous flowing number. We save 10 percent this year, next year, and so on, in perpetuum (and perhaps ad nauseam). Somehow, I don’t believe this will work. We can streamline our systems and improve our processes. We should expect continual improvement but common sense tells us the returns will diminish over time.

Malcolm
Personally, I don’t like long-term MRO contracts. In my experience, the longer the contract, the poorer the service becomes over time. (With service contracts, it’s different.) Sorry. Extra work or not, I’d negotiate every year on many MRO items but maybe that’s just me. I think most purchasing departments would too if they weren’t so darned understaffed.

So, what is the answer?

Frank, there seems to be way too much distrust out there between buyer and seller. I’m your opponent, not your enemy. We need professional transparency on both sides and we just can’t simmer for three years. Unfortunately, the Mahogany Row types demanding the 20 percent price decreases or insisting you maintain pricing for the next five years are too often owners or boards or company officers who look at pie charts all day. They don’t give a damn if you have mistakenly included an electrical substation in your market basket. But fear not, there’s always a solution. Do your homework, prove your point and buyers will make it work. Don’t believe me? Try it.

Sellers must learn to prove their value. They must also demonstrate that value with six-foot posters if that’s what it takes, to be heard by purchasers. Somehow this isn’t happening. Buyers and procurement managers must have more information. They require factual pertinent data, not long-winded parables about sales in the hazy past.

Sales reps must learn what the buyer is thinking and buyers must understand what the distributor is facing. (On most days, all buyers can think about when you’re talking is how often your shipments have been late or incomplete over the past six months.) We must learn to compare notes and propose solutions. Frank, even with that killer physique of yours, I’ll beat the living daylights out of you in the ring (if I could, that is) but after the bell rings, I’ll be the first one over to your corner to see if you’re OK. OK?

The second-to-last word is this. If all of us don’t soon get our acts together in North America, most of what we hold dear today in industrial distribution and manufacturing will be loosely wrapped in wrinkled brown rice paper and hail from the East (and I don’t mean Boston).

Frank
Thanks for letting me have the last word, even if it is to say you’re right.

This article originally appeared in the May/June 2007 issue of Progressive Distributor. Copyright 2007.

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