Many come to us with this question, “What is a performance bond, and when do I know when to require one?” This post aims to answer those questions.

Procurement professionals often begin their careers as buyers of goods. Later, they often find themselves buying more and more services. Sometime during that transition, they will come across the issue of requiring suppliers to obtain performance bonds as part of contractual relationships.

What is a performance bond?

A performance bond is a financially backed guarantee purchased from and underwritten by a third party, such as a bank or insurance company. According to Investopedia, a performance bond is “issued to one party of a contract as a guarantee against the failure of the other party to meet obligations specified in the contract.

For example, a contractor may issue a bond to a client for whom a building is being constructed. If the contractor fails to construct the building according to the specifications laid out by the contract, the client is guaranteed compensation for any monetary loss.”

When to require a performance bond

So, when should a procurement professional require a performance bond of a supplier?

The first thing you have to do is be familiar with the industry and understand routine practices in that industry. For example, performance bonds in the construction industry are prevalent. But if you asked an office supplies vendor to get a performance bond as part of their contract, they would probably look at you with confusion!

For those industries where performance bonds are used but perhaps not used in every situation, deciding on the performance bond issues requires you to understand your risk: the likelihood of a supplier failure and the financial impact of a failure on your organization.

If the likelihood of a supplier failure is high and the financial impact of a failure would be devastating to your organization, then a performance bond is an essential risk management tool. If the likelihood of a supplier failure is low and the financial impact on your organization is negligible, then requiring a performance bond is probably overkill.

Surprisingly, it is common that, in many organizations, the procurement department is the last to be involved in guiding performance bonds. Often, that responsibility is handled by an internal customer department (e.g., the facilities management department) or even the finance department.

While it can be helpful to have a team involved in making determinations about performance bonds, that doesn’t absolve the procurement department from having the necessary expertise in the subject matter.

Moving forward, take a step to learn more about performance bonds and to communicate with others in your organization about how you have used performance bonds in supplier relationships. From there, you can work towards having a better process for identifying when to use them and when not to use them.

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Recommended Reading

• The Complete Supplier Management Strategy
• Supplier Management Strategy
• Supplier Management Metrics
• Strategic Supplier Management
• 15 Rules for Ethical Supplier Interaction
• Assess Supplier Financial Risk
• Managing Supplier Performance
• Procurement Ethics Checklist

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