Contracts That Focus on Lowest Price Can Harm Profitability

by Bryan Lane Berson, Esq.
Download PDF: Supplier Relations

“Point 4 – End the practice of awarding business on the basis of price tag alone.  Instead, minimize total cost by working with a single supplier.” – W. E. Deming

Quality is often defined as “fitness for use.”  As members of a supply chain, manufacturers and service providers use materials from one or more suppliers to create products for their users.  Each party in the supply chain must receive a product that is fit for use so that it can be processed and meet the next user’s needs.  While every link in the supply chain is important, this column focuses on the legal relationship between producers and their external suppliers.

When production is understood as a process, it seems obvious that members of the supply chain should communicate with one another to understand one another’s needs.  Within a single organization, management can implement policies that facilitate interaction among departments and personnel.  The relationship between a producer and an external supplier, however, is more complex because it is governed by contract law.

Contract negotiation can be adversarial or collaborative.  Adversarial parties take self-serving positions.  They might focus on extracting maximum price concessions from one another.  A shortsighted focus on purchase price ignores the total cost of production.  For example, a party who simply chooses the lowest priced supplier may ignore costly alterations further down the supply chain.  A different grade of supplies may require modifications and result in critical quality changes that increase the costs of poor quality, such as warranty costs.  Thus, focusing on obtaining the lowest price alone can actually reduce quality, erode profits, and destroy goodwill among consumers.

Collaborative parties think of one another as partners pursuing a mutual goal or solving a common problem.  Internal customers, purchasing personnel, and suppliers communicate their needs to one another.  They view production and improvement as continuous processes, not a series of discrete transactions.  While each input may not have been obtained at the absolute lowest price, a strong relationship with a dependable supplier that values efficiency, loyalty, and cost reduction can provide additional benefits in the form of greater certainty and higher quality.

The managers, personnel, and legal counsel of all producers and suppliers won’t subscribe to this cooperative approach.  Over time, however, producers with a cooperative mindset will likely discover that most production inputs come from a “vital few” suppliers with whom they can establish their most productive relationships.

The nature of the producer-supplier relationship will influence their contract. At the outset of their relationship, even the most honorable parties must develop trust and evaluate the prospects for their long-term compatibility.  Early on, the parties will likely have a more formal, less collaborative relationship.  As trust grows, the parties will likely streamline the contract negotiations and simplify the legal documentation.

Written contracts and related documentation are prudent business tools that can facilitate any business relationship.  A producer and supplier can use a contract to:

–          establish cross functional teams to discuss needs and concerns;

–          specify performance metrics and means for collecting and measuring data;

–          agree on minimum performance standards relating to defects and delivery; and

–          specify the process for taking corrective action.

To choose and maintain relationships with suppliers, producers must evaluate suppliers’ performance including their quality system, business health, and product quality.

As a prelude to contracting, parties usually conduct due diligence.  A producer may audit a supplier’s plant by sending in an audit team to certify the quality system.  A contract may identify the certification standard (e.g., ISO 9000) that the supplier must maintain.  Producers with sufficient leverage may also require that the supplier adhere to certain covenants or contractual promises to ensure that they maintain their financial health (e.g., a limited level of debt), production capacity, and technological expertise to produce the supplies.

A long, formal contract filled with incentives for good performance and penalties for bad performance won’t help an honest party if the counterparty is untrustworthy.  If you sense that the other party is dishonest, undependable, argumentative, or prone to cause problems, find a more amicable business partner.  By avoiding or ending bad relationships, you can focus on productive ones.  Keep searching until you find them.

About the Author:  Bryan L. Berson, Esq. is an attorney and mediator at The Berson Firm, P.C., a commercial and civil law firm that handles estate administration and planning, real estate, commercial transactions, mediation, and commercial litigation.  His e-mail is bberson@bersonfirm.com.  His phone number is (631) 517-1055.  Connect with The Berson Firm on Facebook and Bryan L. Berson on LinkedIn.  The firm’s website is www.bersonfirm.com.

Disclaimer:  Constructive Knowledge is published by The Berson Firm, P.C. (the “Firm”).  The information contained in this column is provided for informational purposes only.  It is not tax or legal advice on any subject matter.  No readers, clients or otherwise, should act or refrain from acting on the basis of any content without seeking appropriate legal or other professional advice with respect to one’s particular circumstances.  This column reflects a general discussion of the law in New York.  It may not accurately reflect the law of other states.  The content is general information and may not reflect current legal developments, verdicts, or settlements.  The Firm expressly disclaims all liability with respect to acts taken or not taken based on any or all content of this column.  This column is Attorney Advertising.  IRS Circular 230 Legend:  Nothing in this column is intended to be used and cannot be used to avoid U.S. federal, state, or local taxes.  It was not written to promote, market, or recommend any tax planning strategy or action.  CopyrightAll rights reserved.  No part of this publication may be reproduced without prior written consent.  Readers may share this column through, but not limited to, social networks.

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