5 July 2004
Supply chain management is critical to business success in today’s fiercely competitive global market. Craig Neame explains why
Getting products to customers consistently quicker than competitors enhances a brand and improves cashflow. Cutting inventory reduces financing costs and eliminates the need for costly warehouses. Removing warehouses from a balance sheet improves return on capital and eliminates overheads from the profit and loss account. The benefits of good supply chain management go on and on.
To deliver best-in-class supply chain management, manufacturers, traders and retailers are increasingly outsourcing non-core ‘logistics’ functions to specialist logistics service providers (LSPs), which now manage these as a core competency under ‘contract logistics’ arrangements.
As well as improving supply chain efficiency and reducing costs, the employment of an LSP should also enable the customer, free from distraction, to concentrate on its own core competencies, such as branding, product development, customer service and manufacturing or retailing.
According to a recent survey by business intelligence consultants Analytiqa, the European contract logistics market generated €31bn (£20.68bn) in gross revenue in 2002. This is predicted to reach a staggering €59bn (£39.37bn) by 2006. Far East gross revenues are predicted to be even greater, reaching a colossal $75bn (£43.2bn) by 2006.
Third-party and fourth-party logistics providers
So who are the LSPs in this expanding market and what is being outsourced? According to conventional wisdom, LSPs fall into two categories: third-party logistics providers (3PLs) and fourth-party logistics providers (4PLs).
3PLs are ‘asset-based’ organisations, owning distribution centres, vehicles and materials-handling equipment. Some even own ships and aircraft. 3PLs generally market ‘bundled’ services comprising business process management (document production, inventory management etc) and physical logistics activities such as transportation and materials-handling. Wherever possible, 3PLs employ their own assets and services to meet their customers’ needs and requirements. The first 3PLs to develop in the UK were those with haulage units undertaking the domestic distribution of consumer goods, including Exel and Wincanton.
In contrast, 4PLs are said to be ‘non-asset-based’ business process management organisations, managing on behalf of their customer as ‘lead logistics providers’, physical logistics services provided by subcontracted hauliers, ship operators and warehouse businesses. At the core of a 4PL is generally a powerful IT platform and a workforce skilled in management.
The reality, however, is that there are hardly any true 4PLs.
Although companies such as Bernard Group and UTi generally avoid buying assets, allowing them to use best-in-class subcontractors and reducing balance sheet exposure, they might better be described as ‘3.5PLs’, because, where there is a business case, most make limited investments into warehousing, vehicles and handling equipment. It is also true that 3PLs sometimes provide services as 4PLs using their own assets on a limited basis.
The range of services provided by LSPs has expanded enormously during the past five years and this trend partly explains the sector growth. Historically, LSPs focused mainly on domestic distribution, temporary storage, freight forwarding and transportation.
Nowadays, however, LSPs not only manage these ‘commodity’ functions, but many also manage ‘value-adding’ functions formerly considered part of their customers’ manufacturing and/or core businesses.
For example, LSPs are involved in ‘assembling’ finished goods, such as fitting seats into cars or batteries into fork-lifts. They also ‘kit’ finished products, such as packing PCs into packaging together with a keyboard, mouse and instructions. Some have even started buying raw materials on behalf of customers, financing purchases with their own cash and providing credit to customers.
LSPs and their customers also integrate IT systems, sending and receiving data, thereby eliminating costly manual double-keying processes. Customers’ systems are also installed at LSP facilities, where they are operated by LSP staff to expedite purchase orders and produce commercial documentation.
Contract logistics agreements
As the reader will appreciate from above, many LSPs have now, literally, become part of their customers’ ‘DNA’. As such, both LSPs and their customers need comprehensive legal agreements to underpin their relationships.
Obtaining advice from a specialist lawyer is essential. New ‘value-adding’ services mean new risks for both LSP and customer, and a poorly drafted agreement can lead to disaster. While an efficient supply chain can lead to commercial advantage, a failing supply chain can lead to commercial failure, because lead times increase, inventories rocket and customers are lost.
The complexity of a logistics outsourcing agreement will depend upon the nature and scope of the services provided. A simple agreement may cover transportation only, but a complex contract may cover customs management, warehousing, assembly, kitting, facilities management and IT operations.
The key to any successful outsourcing agreement is for buyer and seller to work together in a genuine spirit of ‘partnership’. Most outsourcing agreements last for at least three years and Pyrrhic victories obtained by one side prior to commencement can mean resentment by the other for the duration of the agreement.
In the most successful agreements, the services are defined clearly in language comprehensible to layman and lawyer alike, and the parties are contractually encouraged to work together to identify and deliver savings and efficiency gains, sharing risks and rewards.
The service levels are written down and detailed operating procedures outline how both parties will realise the service requirements.
Realistic and achievable key performance indicators (KPIs) are set, with the LSP instructed not only to report non-conformances that it caused, but also those caused by the customer, such as a failure to make documents available on time. Customers also need to know where they are failing to improve.
With contract logistics, the devil is in the detail, and the draftsman needs an understanding of each KPI’s commercial context and the skills and experience to draft wording to reflect the parties’ objectives. This skill is becoming increasingly important, as many agreements incorporate liquidated damages entitling the customer to discounts on charges where the LSP fails to meet KPIs. Badly drafted KPIs linked to liquidated damages can mean no remedy for a customer for underperformance and/or losses for the LSP, neither of which are desirable in the long term.
Liability provisions are also critical. Is the LSP an agent or principal?
There have been numerous contracts where LSPs have unwittingly undertaken more than they are insured for. Is the LSP responsible for late delivery consequential losses? Is there to be a limitation of liability per incident and per year in aggregate, and is adequate insurance in place? Many contracts fail to address this, leaving LSPs with unlimited exposure and customers with no remedy if the LSP goes bust following a catastrophic incident. If the services include warehousing, how will the parties deal with ‘shrinkage’ and system inventory errors? If the LSP is undertaking assembly work, will it have a product liability exposure, and if so, how will this be dealt with?
When the outsourcing involves the transfer of assets from the customer to the LSP (such as automated picking equipment, kilostream lines and software), the parties need to define any warranties provided by the transferor. Property issues also arise if the LSP procures premises specifically for the services. Where the agreement provides that functions previously undertaken by the customer are transferred to the LSP, the Transfer of Undertakings (Protection of Employment) Regulations may apply.
With some of the most complex contract logistics arrangements, customers and LSPs have even set up joint venture companies, thereby allowing customers to retain a logistics capability while at the same time leveraging the LSP’s specialist expertise and buying power with subcontracted service providers. With a joint venture company, shareholder agreements have to be drafted, and data protection issues and the ownership of IP rights may become more complex.
However complex the outsourcing agreement is, the draftsman should never forget that contract logistics is mainly about the delivery of service improvements and cost reductions in the short term, and continuous supply chain improvement in the long term. This being the case, for both the customer and the LSP, an ideal agreement is a balanced one, sufficiently robust to enable the customer to procure continuous improvement and sufficiently attractive to encourage the LSP to invest in the relationship.
Craig Neame is an assistant at Holman Fenwick & Willan