Today’s competitive economy and the constant need to improve productivity and do things “faster, cheaper and better” has created a growing market for specialist providers of third- party logistics services. Outsourcing all or part of a company’s supply chain function, whether it be outsourcing of the private fleet maintenance or certain technology functions or the private fleet itself, is an important consideration.

According to Steven Trumper, partner of Osler, Hoskin & Harcourt, outsourcing can offer significant potential advantages. Some of the key attractions include:

* Reduced capital investment in real property, capital equipment and information technology infrastructure.

* Access to specialized “best-in-class” expertise and new technology (e.g. RFID).

* Better visibility for the customer on supply chain costs.

* Opportunities for process improvement and better risk management (e.g. labour disruption).

One of the key challenges for customers in completing a third-party outsourcing arrangement is negotiating the pricing arrangements. There are generally two pricing models in the supply chain context:

Base Fee Plus Unit Pricing

In the first model, the price charged by the service provider includes two components: (i) a base fee (usually paid monthly) to cover fixed costs such as facility lease costs and capital equipment leases; and (ii) a variable fee (also usually paid monthly) to cover costs (such as labour) that flex with changes in product volume moving through the supply chain.

Another adaptation of this model is per unit pricing with minimum volume guarantees. If the minimum volumes are not achieved, the customer must compensate the supplier.

According to Trumper, “the key advantages of this price model are the ability to combine price certainty (for both customer and supplier) with the flexibility to adapt to changing market conditions. The disadvantage from the customer perspective is the lack of visibility on the supplier’s cost structure and profit margins.”

“Cost-Plus” Transactions

An alternative pricing model for supply chain outsourcing is the “cost-plus” transaction. In this approach, the outsourcing service provider is compensated for its costs plus an agreed percentage margin (sometimes capped at a total dollar amount).

The advantage for the customer in a cost-plus transaction is that it has full visibility on the supplier’s costs and profit. The challenges to implementing this model include:

* Agreeing on the yearly budget and productivity measures.

* How to encourage the supplier to reduce costs (e.g. gain sharing).

* How to allocate shared costs (e.g. supplier IT platform) between customer and supplier where many customers may share the same supplier infrastructure.

Discretionary Termination

Another important financial issue that frequently arises in supply chain outsourcings involves termination rights. More and more customers are demanding maximum flexibility in their supplier relationships, and in particular, the right to terminate supplier contracts on short notice. Since a supply chain outsourcing may require significant long-term investment by the supplier (e.g. real estate, IT systems etc.), there is a risk that early termination will expose the supplier to substantial financial losses.

To mitigate this risk, suppliers will often require the customer to compensate it for unamortized capital costs if the customer wants an early termination right. Customers will want to ensure that they understand the nature of these costs before agreeing to this approach.

Trumper believes that outsourcing of supply chain functions offers many potential competitive advantages to customers. “Pricing will generally be one of the most important considerations in making the decision to outsource, and there are different pricing models that may be appropriate depending on product profile, operational risks and the customer’s financial goals,” he says. Since outsourcing is ideally a long-term relationship, both customer and service provider have a vested interest in ensuring that the chosen pricing model provides appropriate financial benefits to both parties.

(Steven Trumper can be contacted at (416) 862-6562 or strumper@osler.com)

Mark Borkowski is president of Mercantile Mergers & Acquisitions Corporation. He can be contacted at (416) 368-8466 ext. 232 mark@mercantilema.com