What is the difference between closed and open book contracts?
A current trend in the contracting of outsourced logistics services is towards more transparency in supplier pricing. Buying organisations want to know that they are getting value for money, that the provider of 3PL services is not making excess profits at their expense. One way this can be achieved is through exposing the cost drivers such as labour, materials, overheads, profit and the contingency provision to close scrutiny. Who doesn’t want to understand the real costs of a service and whether they are being overcharged?
In a closed-book contract the 3PL service provider does not offer to divulge its operating costs, overheads and margin to you, the customer. Fees are agreed in the contract and future adjustments are subject to negotiation between the parties at pre-defined intervals. Any data used to set pricing should be based on reliable market information and benchmarking. In this type of contract, the customer does not have access to audit the supplier financials. Their working relationship is based on trust and the continuity of a satisfactory level of service. Closed-book relationships may work well; success may depend on factors such as the extent and complexity of services and the mindset of the buyer. Let’s look at the open-book option.
In an open-book contract, in its simplest form, the supplier bills the customer based on the actual costs incurred for each type of service plus the agreed margin. This type of arrangement is sometimes called a cost-plus contract.
Open book contracts allow us to see into our suppliers business and understand their pricing and margins. When negotiating open book contracts it is advisable to include discussions with the supplier’s commercial, legal, finance functions and not only supply chain.
Sophisticated and experienced customers of 3PLs do not want risk paying premiums and inflated margins hidden in a closed-book scenario. The open-book relationship should ensure that a competitive price is obtained and that the 3PL is being honest in its operations.
This method is especially useful when the services are difficult to specify precisely up front. Open-book contracts often include incentives (and penalties) calculated as a percentage of the difference between the real cost of the project and an estimate that is provided up front.
Open-book sounds ideal but there are drawbacks. Some of the challenges relate to the type of pricing model chosen and the level of actual monitoring and involvement on the buyer’s side.
The most common pricing approach to a full range of logistics services, including warehousing, is a hybrid of some fixed price elements and some variable. Both parties must define pricing for the fixed and variable portions and agree on how these will be adjusted as volume and capacity change over the lifetime of the contract.
The fixed-cost component normally includes the charges for warehouse space, leasing of mobile and static assets, information technology and management overheads. The activity rates or variable fees are derived from actual warehouse activities and physical movement of product. The benefit of the hybrid is that the fixed-cost portion is a “known” and the variables are unit prices based on real volumes.
For the 3PL service provider to manage the variable costs he needs to have a costing system that tracks the detail of the activity and volume throughput. Open book means transparency and access to operation and financial information for both parties but this is often a stumbling block as the 3PL’s financial systems may not offer the full functionality required.
Fully fixed price contracts are rare as the contracted work often varies over time and seasons and it is difficult for the 3PL to accurately plan its cash flow and resources which may be a disadvantage for the buyer as well. Activity-based pricing only has some benefits for the customer that has erratic demand patterns but it is not an attractive solution for the 3PL that has to optimally resource its business assets.
Some 3PLs offer other “free” services. Nothing is for free, look for these costs that are embedded somewhere else in the pricing
Hybrid pricing models lend themselves clearly to open-book contracts. However, open-book is not much use as a technique or process unless we do something with the information that we have gained. In itself, the data is useless. The objective is to use this knowledge to drive benefits. How will you do that?
Of the number of customers that negotiate open-book contracts in logistics, few of them actually interrogate the information or conduct regular supplier audits once the contract is in place. The buying customer often underestimates the time, expertise and effort needed to manage the relationship properly. This is the classic conundrum: Control vs the cost of control.
There are many contentious risk issues to be negotiated in 3PL contracts; liabilities, ownership of assets, consequential damages and losses. For example, arguments also often arise about where and how to provide for and apply contingencies. This should be agreed and confirmed in the contract.
Whichever type of contract is chosen and entered into, all other contract management best-practice principles apply. We need our 3PL supplier to remain in business for the long term. Without a fair and market-related profit margin, his business may fail which is the biggest risk for you, the customer.
SCCG can help you to optimise your supply chain operations. We provide capacity and productivity solutions in fast-changing business environments.
Our directors are experienced logistics consultants who have worked closely with clients in a range of sectors and countries to improve or expand their warehouse and distribution centre operations.