The outsourcing of Logistics services continues to be a growing trend, and can encompass a very broad range of services. This article will focus only on outsourced warehousing contracts, and 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 outsourced warehousing contracts. The specific focus of this article, is on traditional Third Party Logistics (3PL) contracts and the types of pricing mechanisms available for use within warehousing contracts, and does not cover other very important aspects such as:
- Planning and management of the selection process.
- Contract negotiation.
- Implementation and ongoing contract management.
The reasons for this growth are many, but primarily, that Logistics Service Provider’s (LSP) customers believe they will gain benefits such as these shown here.
Whilst reducing cost, is generally a major objective in outsourcing, it may often not be achieved, as simplistically, it may not be possible for the LSP to carry out the same operation as the customer currently conducts in house, at a reduced cost, whilst also making a profit margin. Where the existing in-house operation is very inefficient, inappropriately resourced or could gain significantly from being incorporated into a larger operation, then of course savings may be possible.
From this point on, when referring to outsourcing, it is the outsourcing of warehousing only that is being referred to.
The primary benefit of warehouse outsourcing should probably be thought of as gaining flexibility. This can relate to being able to handle peaks and troughs in demand, acquisitions, geographic and product line expansion and the like.
A critical stage in the outsourcing process is the structure of the contract and in particular the pricing mechanism. Research has shown that up to 80% of Supply Chain costs may be locked in at the design stage of the Supply Chain. So reducing costs post implementation can be very difficult. Most of the post implementation problems that LSP customers face can probably be traced back to poor contract structure and negotiation. It is the contract and the joint process of constructing the contract that will set in place the expectations of both parties and of course the drivers of behaviour. Typical post outsourcing implementation issues can range from poor service to increasing costs, often all put down to the non disclosure by the customer of critical information.
Cost v Price
One of the key aspects of structuring an outsourcing 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 one element, but the detailed picking, packing and despatching activity can be a significant cost driver.
Detailed information on SKU (Stock Keeping Unit) numbers, 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 LSP 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 easily be established, which all underpins more accurate contract costing.
With a high degree of confidence in the resources required and hence the costs involved in providing the service, it is then a comparatively easy step to structure the commercial framework of the outsourcing contract.
Each Parties Objectives
It is not uncommon, for each party in an outsourcing contract can have objectives or agendas that conflict.
A well constructed contract and pricing mechanism will go along way to mitigating these potentially conflicting agendas.
There are some general principles and considerations that should be accounted for in structuring the commercial part of the outsourcing contract. These will include the following:
- The LSP will require a base level fee, or agreed minimum level of income that is not volume related, in order to cover some fixed costs. To do otherwise exposes the LSP unfairly.
- The fee for service paid, should fairly reflect the resources required and costs being incurred by the LSP.
- The fee structure should encourage improved service performance.
- The fee structure should encourage a cost reduction culture.
- The fee structure must be sustainable, through changes in the customer’s operating environment.
- The LSP should have the opportunity to improve profit margins through adding value and innovation beyond the basic services required.
Sadly, many companies approach a LSP outsourcing contract as procuring a commodity and the over riding goal becomes the achievement of the lowest possible unit cost. This approach can be extremely counter productive and costly in the longer term.
Types of Outsourcing Contract Pricing Mechanisms
There are broadly three types of outsourcing contract pricing mechanism that can be used, with variations that can be bolted on. These are:
- Percentage of Sales. Whereby the LSP fee for service is based upon an agreed % of the sales value of the product handled.
- Cost Plus. Whereby the LSP declares what resources and costs are required to conduct the service and an 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:
- Gain Sharing. Whereby cost savings initiated by the LSP or customer will be shared.
- Performance Based Logistics (PBL). Whereby fees or more likely contract profitability, are directly linked to agreed performance targets.
Percentage of Sales
This type of outsourcing contract is still widely used, particularly with distributors rather than LSPs. It might be considered as a rather ‘lazy’ approach by the customer to outsourcing contract pricing, as it may bear no relation to the resources and 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 LSP benefits from economies of scale. The reverse is also true of course.
Where this form of pricing is used, it is important to establish limits or parameters to the service that will allow fee percentages to be adjusted if required. It is also vital that the customer is 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.
A rate based 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 being carried out, as well as protection for both parties, should the customer’s business change, in relation to volumes or order profiles. These types of change can have a significant impact on the LSPs 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 required. Often, a fixed monthly fee is utilised to help offset the LSPs fixed costs, with a variable fee structure then being applied for the various activities being carried out. These activities might include receiving and putaway, picking, despatch and the like, with different rates being applied for unit, carton and pallet picks.
Consideration must be given to the impact of increases or decreases in storage needs, in throughput volume and changes in the picking profile. All of these can be adequately catered for within the fee structure if based on sound analysis, forecasts and fairness.-
A gain sharing formula can be applied to any outsourcing contract type. The basic concept is that should the LSP, or indeed the customer, identify opportunities to improve the operation and reduce costs, that those cost savings 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 is a disincentive for the LSP to seek performance and cost improvement.
Performance Based Logistics (PBL)
Performance Based Logistics or PBL is a term that has evolved from the US Defence industry, and as the term suggests rewards and penalises the LSP based on performance against agreed service targets.
It should not be seen as yet another adversarial means of managing an LSP, but as a genuine means of encouraging and rewarding superior performance.
This pricing approach will generally be structured so that the LSP’s profit element can be increased or decreased, rather than attacking the LSP’s total income. In this way the right performance is encouraged, without openly putting the LSP’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 erode base fees, not merely profit margins. But appropriate review and mediation clauses should avoid this point being reached.
In summary, this article has attempted to highlight, albeit at a high level, the range of common warehousing contract pricing mechanisms that can be utilised, and some of the advantages and disadvantages of each. Which ever pricing mechanism 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 an LSP has been short listed for a contract).
Considerable outsourcing experience has shown that the failure of pricing mechanisms and often the inevitable contract failure can usually be traced to poor planning, communication, resourcing and costing, right at the start. Bearing in mind that 80% of Supply Chain costs can be ‘locked in’ at the design stage (see Introduction above), this phase of outsourcing can prove to be the most critical.
On a final note, whilst this article has been focused on the establishment of new warehousing contracts, it is not impossible to also review and revise existing contracts and pricing mechanisms.