When getting suppliers to take the risk doesn’t always pay off

Risk allocation in contracts is one of those iceberg issues.  I suspect a lot of people on both buy and supply side rarely think about it consciously, let alone in a structured manner. Yet it can have a major effect on how good a contract and deal you finally get. Here' s an example of what we mean.

There's a major contract out to tender at the moment that includes a large element of paper and paper based products. The tender asks the bidders to offer a price that will be fixed for six months minimum.  That would seem to give the buyer some protection against potentially volatile market movements.  - important given the way pulp and therefore paper prices have moved over the last few years.

But let's think about what will really happen. The bidders have three choices. They can quote a price based on current prices, and hedge to give themselves some protection - buy ahead basically. But that is tricky, as the volume to be provided is rather vague in the specification.

Or they can quote an aggressive  price based on current price (or even lower) and just hope the market moves in the 'right' direction without taking that hedging approach.

Or they can quote a cautious price, allowing a reasonable margin for adverse price moves.

But of course that cautious strategy  probably won't win the supplier the contract. And even hedging incurs a cost - so there's every chance the contract will go to the 'take a chance' provider.  And if that is the case, this is a no-win outcome.

If the market price declines, their agreed price may well look uncompetitive pretty quickly.  And the buyer then pays over the odds or (more likely) the budget holders won't use the contract at all - a problem whoever wins the contract.

But if the price increases, then the provider is exposed (without hedging).  So there' s every chance they will come back and say, "'we just can't supply at this price. You don't really want us to go bust, do you"?

So while the transfer of risk to the provider might look sensible at first sight, it may not benefit either party under most of the potential outcomes. Better perhaps to have a price linked to market pulp price, plus a keenly negotiated management and profit fee. That should guarantee a competitive price, whatever happens in the market.... and congratulations to a couple of organisations I know who have recently done exactly this!

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  1. Andrew F Smith:

    The allocation of risk represents a real dilemma in many big deals. In big businesses, and indeed government, the stakeholder is usually keen to have a fixed price for as long a period as possible in order to provide budget certainty and therefore help them deliver their KPI’s. However the procurement professional will normally will tend to be keen on a greater share of risk given that the supplier will more likely offer a better deal (helping them deliver their KPI’s) if they can protect their margins by having some degree of movement against agreed industry indexes. Accurate baselining and clear set of objectives (agreed by all) at the start of any tender process is key to minimise this issue when it gets to the award decision.

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