March 2004 | Commentary | 3PL Line

Please Don't Squeeze the 3PL

Tags: 3PL

When is it practical to develop a cost-plus relationship? Many companies that outsource spend up to 60 percent of their logistics management time defining, selecting and negotiating the 3PL agreement yet do not fully realize the total benefits available from the outsourced relationship. The cost-plus agreement must allow the outsourcer to maximize the ROI from high-impact, process improvements.

Why don't all 3PL agreements have a bit of cost-plus negotiated into a written understanding? Many outsourcers believe that a 3PL has no incentive to control cost with a cost-plus contract. Yet how does the price-squeezed 3PL contract motivate high service levels, high transactional quality, and accurate inventory control?

A Cooperative Approach

A simple cost-plus framework with the proper matrix of performance standards, targets, monitoring mechanisms and risk identifiers, can result in an environment of true cooperation. In this environment, both parties can better address all the important logistics improvement opportunities with tools that help people create, access and share critical performance information.

In a traditional transaction rate environment, the operating information (productivity and cost) is typically not shared with the outsourcer as long as the 3PL is achieving its internal targets. Not until the operation deteriorates and the margin is compromised does the 3PL share this information in a collaborative effort.

The outsourcer has limited incentive to help the 3PL by streamlining inbound processes, sharing planning or forecast data, or soliciting valuable input from the 3PL that has a broad base of experience.

Under this scenario, the outsourcer loses an opportunity to gain increased understanding of his business and may actually be leaving improvement opportunities on the table. A great way to start a business relationship is by establishing an open-book P&L relationship so both parties can learn the business activities and issues that will impact cost, service, quality and inventory accuracy.

With a healthy and properly structured cost-plus relationship, companies have the ability to effectively manage their information and make educated decisions regarding all aspects of their logistics business.

A well-structured cost-plus relationship can therefore drive improvements to total logistics performance. Any methodology that educates the outsourcer and 3PL on business processes and the bottom line provides everyone with a powerful managerial tool.

When the partners enhance this process with built-in gain sharing, they create a win-win situation for both the outsourcer and the 3PL because the rewards to both parties are contingent upon the performance of the team.

In addition to measuring cost, the team must also focus on quality and customer service improvements. Cost, quality, service, and inventory control metrics prevent a pure cost focus, which can result in adverse effects on quality and customer/consignee satisfaction.

Several examples of consistent performance standards to consider are:

  • Cost Reductions: establish a minimum and maximum standard per dollar value.
  • Productivity: take the number of cases per hour worked (minimum and maximum standard cases or pallets per hour), and divide by total hours.
  • Quality: OS&D (minimum and maximum percent), divide the number of credits issued or cases impacted by the number of shipments or cases shipped.
  • Service: the on-time shipping percent (minimum and maximum percent), excluding CPUs, carrier delays, or other events beyond the control of the warehouse.
  • Customer Complaints: (zero defects) documented by customer service.
  • OSHA Injury Rate: (zero defects) the number of points awarded after three consecutive months of injury- free operation.

Once both parties identify the criteria, they should assign each line item a point value that corresponds to the increase in margin that can be earned by the 3PL for exemplary performance. Each metric should have a reasonable and realistic range, and each metric can be weighted for its relative importance to the operation.

Typically productivity has the greatest impact on total cost and has the highest upside weighting. A good cost-plus agreement thus has a minimum percentage base charge against P&L costs and a performance incentive based on the weighted results of the actual performance.

The 3PL then has an incentive to reach for a maximum margin percentage based on effective management of all aspects of the operation. The outsourcer has an incentive to listen and respond to improvement opportunities the 3PL offers to increase the operation's effectiveness.

When the outsourcer and 3PL have established open communication, defined the ground rules of performance and scheduled the monthly review meetings, then—and only then—will the partners begin to realize the full impact/return of a cost-plus agreement. The monthly review meetings can be in-person or via conference call but are a critical element of achieving the full benefit of the properly structured cost-plus relationship.

The communication and resolution of real issues that impact all aspects of the operation produce significant benefits. Instead of outsourcing merely as a tactical means of driving costs and efficiencies out of a business process or function, the outsourcer begins to use the outsourcing relationship to strategically conduct business better than its competitors.

Here are some of the benefits of cost-plus agreements and outsourcing:

  • Outsourcing enables a company to maintain agility and flexibility as it grows and changes—especially through mergers, acquisitions and divestitures.
  • Cost-plus should be a pay-for-performance process with built-in incentives to achieve common objectives.n Outsourcing and cost-plus are about more than reducing fixed costs.
  • A properly structured agreement includes an effective incentive for continual cost reduction and improvement of performance across all aspects of the operation.
  • An effective relationship creates an educational process with a win-win result.
  • Both parties gain an increased understanding of costs for the outsourcer and the 3PL. The focus is then on paying the real cost of the activity, eliminating averaged rate-factored variances and driving out the unnecessary overhead resources.

Let's stop a minute and review a typical transaction rate charge such as, cost per/case plus accessorials, cost per/cwt plus accessorials, cost per/line item or order plus accessorials. When a variety of products are grouped together for the convenience of charging a rate to handle or store, averages of averages are used to determine the rate.

The 3PLs that quote this business try to cover their risk of exposure to adverse changes in the activity profile of the account. The more blended and uncertain the data, the greater the risk factors that must be applied to protect the 3PL from unknown operational conditions that may or may not transpire. All costs of doing business are calculated into the transaction rate proposal, and the factors can only be based on averages of averages.

Establishing Accountability

A properly structured cost-plus business agreement forces the outsourcer to get involved in the operation and hold all parties accountable for their actions. In a transaction rate environment, however, the outsourcer pays the agreed rate and listens for customer complaints, 3PL complaints or other error soft points.

A properly structured cost-plus agreement encourages meaningful communication, dialog, and problem solving. During the monthly review meeting, the outsourcer should also hold the 3PL accountable for monthly cost variances and analyze plan vs. actual reports.

Both parties must be careful not to make a business decision that unknowingly affects the ability of the other party to generate service improvements or cost savings. The team is then free to serve the needs of the outsourcer's customers in a proactive, cost-effective manner.