3PL Warehousing Contracts – Avoiding Mistakes! VIDEO

Drive the right behaviour with your warehousing contractor. Get the pricing / rate structure right and things will be a lot easier.
I’ve been involved in many Logistics Outsourcing contracts in my role as a consultant (in many different countries) and I hope these tips will help you avoid some stress and money!

“Here at Logistics Bureau, we’ve been involved in preparing or auditing hundreds of outsourcing contracts over the years. This video is intended to be a guide for those companies considering the outsourcing of warehousing or indeed those companies that may wish to review and renegotiate existing warehousing contracts.

My specific focus is on traditional third party logistics or 3PL contracts and the types of pricing mechanisms available for use within warehousing contracts. So I won’t be covering in this video other very important aspects such as planning and management of the selection process, contract negotiation or implementation and ongoing contract management.

Outsourcing logistics services continues to grow globally and probably now stands at about 80%. The reasons for this growth are many but primarily, that 3PL customers believe they will gain benefit such as cost reduction, service improvement or access to specific resources and technologies.

A Critical Stage in the outsourcing process is the structure of the contract and in particular the pricing mechanism. Researches are shown that up to 80% of supply chain cost maybe locked in at the design stage of the supply chain, so reducing cost post implementation can be very difficult. Most of the post implementation problems that most 3PL customers face can probably be traced back to poor contract structure and negotiation. It’s the contract and the joint process of constructing the contract that will set in place the expectations of both parties and of course become the drivers of behaviour.

Typical post implementation issues can range from poor service to increasing costs often all put out down to the non-disclosure by the customer of critical information. One of the key aspects of structuring a contract is understanding the resources and hence the costs involved in its performance. This is best achieved by open discussion and analysis of the activities and product volumes involved. Storage requirements at various times through the year are 1 element, but a detailed picking, packing and dispatching activity can be a significant cost driver.

Detailed information on stock keeping units or SKU’s, their range, size and weight are important. As are the details of past and forecasted order profiles right down to order line items. This level of detail enables the 3PL to profile the number of pick locations required and the actual number of picks being made on a SKU by SKU level. Accurate calculations of storage and handling equipment needs as well as labour requirements can then be easily established which all and depends more accurate contract costing.

With a high degree of confidence and the resources required and hence the costs involved in providing the service, it’s then a comparatively easy step to structure the commercial framework of the contract. We need to recognise that each party in an outsourcing contract can have objectives or agendas that conflict. A well constructed contract and pricing mechanism will go a long way to mitigating these potentially conflicting agendas. There are some general principles in considerations that should be accounted for in structuring the commercial part of the contract and these will include the following;

1. The 3PL will require a base level fee or agreed minimum level of income. That is not fallen related in order to cover some fixed costs, to do otherwise exposes the 3PL unfairly.
2. The fee for service paid should fairly reflect the resources required and cost being incurred by the 3PL.
3. The fee structure should encourage improved service performance.
4. The fee structure should encourage a cost reduction culture.
5. The fee structure must be sustainable through changes in the customers operating environment.
6. The 3PL should have the opportunity to improve profit margins through adding value and innovation beyond the basic services required.

Sadly, many companies approach a 3PL contract as procuring a commodity, and the overriding goal becomes the achievement of the lowest possible unit cost. This approach can be extremely counterproductive and costly in the long term.

Let’s look at the types of contract pricing mechanisms next. There are broadly three types of contract pricing mechanism that can be used with variations that can be bolted on.

And these are;

• Percentage of sales, whereby the 3PL fee for service is based upon an agreed percentage of the sales value of the products handled.
• Cost Plus, whereby the 3PL declares what resources and costs are required to conduct the service and agreed profit margin. the plus is added.
• Rate Based, whereby a rate or price is agreed for each of the activities and services to be performed.

Variations that can be applied to these basic contract forms can include;

a) Gain sharing – whereby cost savings initiated by the 3PL or customer will be shared and
b) Performance Base Logistics (PBL) – whereby fees or more likely, contract profitability are directly link to agreed performance targets.

Let’s look at each of this in term.

1. Percentage of Sales – This type of contract is still widely used particularly with distributors rather than 3PLs. It might be considered as a rather lazy approach by the customer to contract pricing, as it may be no relation to resources or costs of the services being provided. The greatest criticism of this type of pricing is that it offers no benefit to the customer should volumes increase and the 3PL benefits from economies of scale. The reverse is also true of course, where this form of pricing is use it is important to established limits or parameters to the service that will allow fee percentages to be adjusted if required. It’s also vital that the customers involved in the analysis of the resources and hence the costs required to perform the service. Traditionally, the customer has often not been included in this process. The actual percentage charge obviously vary significantly from industry to industry and is heavily dependent on the value of the product being handled. But wide variations within the same industry have been observed and would tend to indicate that the percentage charge established may in some cases not be related at all to the cost of the service being provided, but more aligned with what the market will bear.
2. Cost Plus – this form of pricing is still widely used and is favoured by some of the major 3PLs. It can tend to favour the 3PL rather than the customer and may lead to contracts being loaded up with resources that are not really required or at least not fully utilised by the contract concerned. It can also drive undesirable 3PL behaviours and that the 3PL at least a situation may arise in a poorly constructed contract that the more resources that are consumed, be that storage space or labor, the better. In its favour, though, this form of pricing can often be the only way of pricing a contract at least in a short term where it may be difficult to establish the precise services required or the detailed volumes and order profiles to be handled. This could be the case for example in the new business start-up, entry into a new market, during an acquisition, following a major new product, introduction and the like. However it’s recommended that the pricing mechanism be move to some formal rate based fee as early as possible.
3. Rate Base Pricing – A rate base fee structure tends to offer the best mix. This is due to the detailed work required to establish the rates and also the volume related break points that should also be incorporated. It should result in a fee for service that fairly reflects the work been carried out as well as protection for both parties should the customers’ business change, this is in particular in relation to volumes or order profiles. These types of change can have a significant impact on the 3PL’s resource needs and costs. The basis of this pricing mechanism should be an open and shared analysis of the activity to be carried out and the resources required to provide the full range of services. Often, a fixed monthly fee is utilised to help offset the 3PL’s fix cost with a variable fee structure then being applied for the various activity being carried out. These activities might include receiving and put away, picking, dispatch and a like, with different rates being applied for units of carton and pallet picks. Consideration must also be given to the impact of increases or decreases in storage needs, in proof of volume and changes in the picking profile. All of these can be adequately catered for within the fee structure if based on sound analysis, forecast and fairness.

Next the Add-ons that I mentioned.

• Gain Sharing – A gain sharing formula can be applied to any contract type. The basic concept is that should the 3PL or indeed the customer identify opportunities to improve the operation and reduce costs, than those costs saving should be shared. The exact percentage split of the saving is debatable but it could be argued that 50-50 is the fairest. Without some form of gain sharing incentive, there may be limited ways of encouraging innovation and cost saving within the contract. In fact it could be argued that without such a formula, there’s a disincentive for the 3PL to seek performance and cost improvements=.
• Performance Based Logistics (PBL) – PBL is a term that’s evolved from the US defence industry and as the term suggests, rewards and penalizes the 3PL based on performance against agreed service targets. It shouldn’t be seen as yet another adversarial means of managing a 3PL, but as a genuine means of encouraging and rewarding a superior performance. These pricing approach will generally be structured so that the 3PL’s profit element can be increased or decreased rather than attacking the 3PL’s total income. In this way, the right performance’s encouraged without openly putting the 3PL’s business at risk. An escalation clause would also be used so that repeated performance below agreed targets would at some stage then start to a road based fees, not merely profit margins. But appropriate review and mediation clauses should avoid this point being reached.

So in summary, I’ve attempted to highlight or be at the high level the range of common warehousing contract pricing mechanisms that can be utilised and some of the advantages and disadvantage of each. Whichever pricing mechanising is used, an effective pricing mechanism must be based on detailed, factual information particularly regarding customer product volumes and order profiles as well as a willingness for joint resource planning and contract costing.

This would normally take place after a 3PL is being short listed for a contract. Our considerable experience in this field is shown that the failure of pricing mechanism and often inevitable contract failure can usually be traced to poor planning, communicating, resourcing and costing right at the start. Bearing in mind that 80% of supply chain costs can be locked in at the design stage, this phase of outsourcing can prove to be the most critical.

On a final note, whilst I’ve been focused on establishment of new warehousing contracts, it’s not impossible to also review and revised existing contracts and pricing mechanisms. I hope this has been on interest and if you need any help with your warehousing contracts, do feel free to contact us.”