Guaranteed Cost Saving Contracts
Guaranteed Cost Savings Contracts
The 4th in a series of eight posts titled: “The View From the Other Side”
Imagine that you have just been named Procurement Director. You got this job because your predecessor just didn’t achieve his cost saving goals. You start looking around for a way to impress senior management and observe that the same vendor has had the lion's share of your lab business for a long time. So you go fishing.
A representative from the distributor who is hungry for your business pays you a visit and makes this offer: “We will guarantee you 10% hard cost savings in year one if you will sign a five year exclusive agreement with our firm.” Since you spend around $250,000 on lab supplies, being able to post a savings of $25,000 in your first year on the job looks like a gift!
You call the incumbent vendor and announce that you want the same deal from them. They tell you there is no way they have that kind of margin to give up since they were doing their best to keep the business before you got this position.
If someone made you an offer like this, would you take it?
Why would a vendor make this offer?
Obviously they want new business. The unknown is what you buy and what you currently pay for it. And they are gambling that they can supply everything you buy now from them by sourcing any products they don’t carry through a 3rd party at a price that won’t end up being a significant loss. It’s a gamble.
The quid pro quo here is that in years 2 - 5, they have the contractual right to switch any item you buy to any vendor they choose as long as it is functionally equivalent. That sounds O.K. to you but your lab guy is going to have a lot to say about that! It’s a year down the road and you may have another promotion by then! Someone else can deal with any fallout, right?
From the vendor perspective they may break even or have very thin margins in year one but profits will rapidly ramp up in years 2 - 5. To make sure you deliver the business, there are financial penalties built in for non-compliance. The agreement is non-cancellable. They are granted rights to do audits to ensure compliance with the agreement and make sure you aren’t shopping elsewhere.
If you are not the incumbent vendor and you can’t win the business in any other way, there’s little (but not zero) risk.
The Major Risks to the Vendor
1.) You spend a lot on a few items for which you have no source of supply at a price even close to what you buy it for now less 10%.
2.) You buy a lot of products that have very low margins.
3.) Your sales rep leaves during the first year because this deal yields no commissions.
4.) You have to sue your customer for non-compliance. (This does happen.)
5.) The person who made the deal with you leaves the position/company.
6.) The lab revolts. (This is a likely in year 2.)
The Major Risks to the Customer
1.) The distributor backs out of the deal. (Yes THEY have a cancellation clause!)
2.) You are sued by your supplier and have to defend the suit in court.
3.) You are forced by the distributor to switch to products that may be functionally equivalent but won’t work in your situation.
4.) The distributor rep quits and you have nobody to negotiate with.
5.) The distributor raises prices in year 2+ unreasonably to make up for the loss in year 1.
How common is this offer?
These offers were in fashion 5 - 10 years ago. This was “an offer of last resort.” If the incumbent vendor was entrenched, this offer was designed to break the status quo. Experience has shown that this offer typically results in the competitor winning the business for the period of the contract but not one day more. A customer who has been through this will do everything in their power to find other vendors once the contract ends.
NOTE: The example mentioned above was a recounting of events from an actual Fortune 50 customer.
What we will discuss in this series:
- 1.) Contract Terminology 101 - what are the components and what do they mean to you?
- 2.) Contact vs. Agreement - What’s the difference? Do you have the right to shop elsewhere? What about a “generic” or group contract?
- 3.) The Hot List and Price Caps - The pros and cons.
- 4.) Guaranteed Cost Savings - Hard vs. soft cost savings. Metrics. Penalty clauses.
- 5.) Cost Plus Pricing - Depends a lot on how you define “cost.”
- 6.) Rebates and Prebates - Sound too good to be true? Most likely it is.
- 7.) Profitization - How it’s done and how you can protect against it.
- 8.) LPS On Your Side - The LPS approach. How it addresses these issues and is a better fit for many lab