Special thanks to GEP for this guest post
When you are involved in an RFP process to fulfill a specific business need, one of the most critical factors while negotiating agreements with shortlisted suppliers is the duration of the contract. The business could be awarded for one year or for multiple years. While there is the obvious benefit of a one-year contract (“What if prices in the future go down as compared with the current price?”), there are multiple benefits that come out of a multi-year contract.
- Higher discounts from suppliers
This is one of the most common reasons why multi-year contracts are in place. It is always in a supplier’s best interest to get fixed volumes and repeat business. A commonly used negotiation tactic to get price benefits is to check for multi-year discounts that the supplier might offer. This works well even when you are working with monopolistic suppliers, as they are not open to negotiation but a long-term contract offering always helps when you are at the negotiation table.
- Safeguarding against price volatility (by agreeing to a COLA Y-o-Y change)
Multi-year contracts help insure procurement against any major fluctuations in price. When a price is set at the start of the contract, it helps mitigate risk for both parties (in case of increase or decrease in market indices). In cases of major fluctuation, the parties can share the benefit/risk. However, when it comes to service-based multi-year contracts, suppliers generally ask for a clause which allows for an increase in yearly prices via a COLA (Cost of Living Adjustment) component — an effect of CPI and WPI inflation. The buyer and supplier can mutually decide the source of the COLA component (any website or business) to get this information annually.
- Developing strategic partnerships with suppliers
Many organizations have a robust SRM (Supplier Relationship Management) program where they classify suppliers as strategic or non-strategic. A strategic supplier could be high volume, high spend, and/or for a very critical project. It is important to develop long-lasting relationships with such suppliers to get more benefits for your organization. When suppliers are offered a multi-year contract, there is more commitment from their end, as they can feel assured that they’re on board for the long run.
- Getting suppliers to commit to continuous improvement initiatives
When organizations enter multi-year contracts, they also generally get the supplier to commit to continuous improvement initiatives. As the suppliers obtain insights over time, they become a partner to the overall process and can use insights from past years to suggest programs or process improvement ideas that can benefit your organization.
- Saving time, effort and resources
Procurement spends a significant amount of time, effort and resources to review contracts every year, run the RFP process on key projects and renegotiate with or change vendors. If vendors are changed, a lot of time is spent on knowledge transfer and vendor onboarding. Multi-year contracts help avoid all this and procurement can focus on other strategic initiatives in the organization.
There are times when suppliers demand multi-year contracts. When there is any upfront investment from the supplier side (like in co-manufacturing), suppliers need the guarantee of a long-term contract to reap the benefits of their investment. This investment could be in technology, machinery, people (such as when foreign labor is brought in), time (for initial set-up), etc. In such cases, it is a common practice to opt for multi-year contracts.
Having looked at the advantages of multi-year contracts, it’s also important to take steps to avoid a variety of pitfalls:
- Add an early termination/break-away clause to SLAs/KPIs to set performance benchmarks and address possible issues related to supplier performance
- Give consideration to TCO (Total Cost of Ownership) over the complete contract period and not just annual costs when making the decision to award business
- Ensure that you run a complete RFP exercise and determine responses qualitatively, since it won’t be easy to switch suppliers in between contracts
- Set periodic performance evaluations to ensure quality of work
Entering into a contract with a new (or even existing) supplier is a major decision. There will always be doubts & risks, especially when the proposed contract is for the longer term. However, if implemented correctly, multi-year contracts can address risks while simultaneously unlocking significant benefits for procurement.