Here in the antipodes, contract manufacturing and outsourced service provision relies heavily on “cost-plus” models.
With these types of arrangements, the customer (Contract Owner) outsources a section of their need to a third-party service provider (Contractor), who then performs the work and submits their costs, plus a pre-agreed margin. These arrangements are common in government, contract mining and infrastructure management (roads, rail, ports, water, energy, etc.).
Administering cost-plus contracts is relatively straight forward. That is why they are attractive; one invoice, one payment. However, they are rarely managed well by either side and the contractor churn rate is often unnecessarily high.
The More “Cost” – The More “Plus”
The obvious problem for buyers (Contract Owners) is the more “cost,” the more “plus.” So, in many cases, these models provide a negative incentive for Contractors to improve their procurement activities and become more cost-efficient. Contract owners become frustrated over time because they can’t see what is happening, believe they are being charged too much and then become dissatisfied with the contractor’s performance. They react by attempting to control to the situation, often by adding administrative complexity or pulling back a portion of what they have outsourced.
The most common reactions include:
- In-sourcing the purchasing of materials. This adds unnecessary work to the Contract Owner’s procurement department, complicates the communication layer which can then be a source of finge- pointing and contract delays. The Contractor loses the pool from which to add a plus which can cause them to cut corners and deliver a poorer service overall.
- Pre-set the price for sub-components, such as building materials, of the cost-plus contract. When this occurs, the Contractors can react by building in a buffer for uncertainty, thereby contributing to higher costs than are necessary. Contractor buffers are usually the largest when the contract contains some form of maintenance component. Things don’t usually break on schedule so it is difficult to forecast demand when the problem has not occurred yet.
- Dictate a product source or specific serialised component. This is a strategic sourcing no-no that we hate facing from our internal customers. However, it is surprising the number of times we seek to do it to our Contractors. The contract should be open to purchasing the products and fittings that the Contractors suggest. Don’t mandate things that typically are not that important.
- Re-tender the contract before it expires. Tendering has costs for both sides; they include the cost to develop, submit, evaluate and then the cost to change if the incumbent is unsuccessful in retaining the contract.
The Contractor’s Best Interest?
None of the above is desirable and it is important for procurement professionals to remember that it is not in a Contractor’s best interests to take advantage of ‘the plus.’ Over the long term, they are likely to lose the extra margin one way or another either by losing control and flexibility or by losing the contract.
Most, if not all of these problems can be solved through better information sharing and process transparency from both sides. We’ll explore those solutions in Part 2.
