Best Practices for Evaluating MRO Supply Agreements

Professionals shaking hands over contract

When dealing with general off-the-shelf industrial, electrical, and safety supplies, businesses typically face countless options from a number of major players, all with similar service offerings. To differentiate themselves from the pack, many of these companies are getting creative with contract terms and value-adds to create the perception of cost savings beyond competitive unit-cost pricing.

While on paper — or more commonly, on PowerPoint — these programs and initiatives do appear to offer cost savings opportunities, they are often a smokescreen to distract from an overall uncompetitive program. On top of this, they often come at a high price for you — the customer. This is why it’s so important to understand what is actually on the table before entering into an agreement.

Below are some of the most common items seen on these types of agreements, along with the evaluation practices needed to ensure you’re getting a good deal.

Iterative Savings in Exchange for Additional Volume

In particular, the promise of 1-3% ongoing cost savings in exchange for a volume growth commitment is showing up more and more in supply agreements. This is especially common in situations in which the potential supplier is aware that other, similar vendors are being used in the same category. Volume increases are typically quite aggressive — 10-25% annually. This is intended to drive preferred supplier status and purchasing compliance across the customer organization.

While on paper, that seems to align with customer goals, this is usually a dangerous clause. At best, should minimum growth requirements not be met, the supplier has full freedom to raise pricing as they see fit. At worst, penalties will be inflicted upon the customer for not meeting growth expectations. Either way, the upside rests primarily with the supplier.

These types of clauses should be negotiated out of the agreement entirely, replaced with a mutual agreement to reevaluate pricing and volumes annually and adjust accordingly, at the acceptance of both parties. This gives an out to an unsatisfied customer, motivating the supplier to keep pricing competitive, and also ensures that core pricing is targeted to the most frequently purchased items.

This type of language can also leave customers blindly transitioning business away from other vendors in order to meet the projected growth minimums and achieve the 1-3% “savings” without evaluating if the new vendor pricing is more competitive. Especially in niche categories such as safety and personal protective equipment (PPE), major industrial vendors are 6-10% above market. Savings of 1-3% may not cover the loss of transitioning these items to a higher-cost vendor. Any transition should first be prefaced with a formal request for quotation (RFQ), giving the customer the opportunity to fully evaluate the cost-benefit of making such a transition.

Category Discounts

For items not included on a customer’s “core list” of frequently purchased items, category discounts are often established to standardize cost reduction on ad-hoc or infrequently purchased items. For example, a contract may state that all items falling under the plumbing category are discounted at 50% off the list price. This makes comparing two competing vendors difficult, especially for a company with a lot of ad-hoc/tail items in consideration.

The first differentiation that needs to be made is whether the discount percentage is applied to the list price or the web price. Most major retailers set a website price that is already at a slight discount compared to list price. Therefore, list-price category discounts should be set at a deeper rate than web-price discounts.

Furthermore, set list or web prices are not always equal for like products. If Major Retailer A has a hammer listed at $15, and Major Retailer B has the same hammer listed at $20, the application of a 50%-off discount to the list price for Retailer A and a 55% discount to the list price for Retailer B would yield a more cost-effective option under Retailer A, despite the lower discount.

To evaluate this when choosing a supplier, it’s best practice to select a sampling of items in frequently purchased categories and apply the proposed discounts. Evaluate like-for-like net pricing to understand the actual value of the discount structure, and make your supplier selection based on that data.

While it’s not uncommon for other, more soft cost savings to be baked into these types of agreements, as long as there is measurable hard dollar value in the unit pricing, category discounts, and product transition analysis, the supply agreement is likely to support a mutually beneficial partnership between the supplier and customer.

Above all, it’s important not to take anything at face value, and perform internal validations into all of the specific program benefits and discounts being offered by a vendor. A vendor that is truly offering a competitive package will be eager to assist in quantifying these numbers and driving transparency in the relationship.

 

Image credit: Pormezz/Shutterstock.com

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