Make sure the price is right

Make sure the price is right

There are three dominant pricing models for outsourced logistics contracts: transactional pricing, activity-based costing and cost-plus pricing. In addition, benchmarking and gainsharing are popular means to determine incentives for 3PL providers.

According to Gene Marino, vice president of global solutions for APL Logistics, shippers should examine the pros and cons of each pricing model to ensure the ultimate outsourcing contract meets your needs. Don't sign a contract that makes you uncomfortable, he urges, and don't hesitate to have a friendly discussion with your 3PL if you feel the proposed billing terms don't satisfy your needs.

Each pricing model, Marino observes, has its own set of advantages and disadvantages:

Transactional pricing
The most popular pricing structure is traditional unit pricing, also known as transactional pricing. With this form of pricing, client companies agree to pay 3PLs a flat fee per unit of work, whether that unit is defined as a mile driven, a pallet loaded, or a case handled.

Pros

  • Fixed terms leave little room for misinterpretation.
  • Pricing is easy to understand and easy to budget (especially when predictable volumes are involved).
  • Pricing structure is easy to design and implement.

Cons

  • 3PLs may feel the need to overestimate their unit prices to minimize their risk and guarantee they'll cover their fixed costs.

Activity-based costing
Clients agree to pay a flat fee to cover the 3PL's fixed costs, including leases, equipment, racking and management. They also commit to a fee that covers variable costs such as labor, fuel and equipment maintenance. Activity-based costing (ABC) is popular with dedicated contract carriage arrangements.

Pros

  • ABC more accurately reflects services rendered and expenses incurred.
  • 3PLs don't have to build fat into their unit prices to protect themselves from losses related to their fixed costs.
  • ABC contracts allow companies to track logistics costs more accurately because they usually have more highly detailed invoices.

Cons

  • ABC pricing structures are complex to develop.
  • Activity-based pricing is difficult to structure for new relationships.
  • There are no inherent financial incentives for the 3PL to pursue continuous improvement without a well-defined gainsharing program included in the contract.

Cost-plus pricing
Also known as open-book, cost-plus pricing is most often used as an interim contractual measure. This structure consists of a fee for the cost of services plus a mutually-agreed-upon mark up or profit margin.

Cost-plus is especially effective if the nature of the contractual assignment is changing. Examples include companies starting new operations, launching a new product or undergoing some other transition that makes logistics requirements volatile.

Pros

  • Cost-plus protects shippers from protective overestimating that may occur with transactional pricing.
  • The 3PL is protected against losses due to unpredictable volumes/business levels.
  • Providers are guaranteed a profit and shippers can keep that cost under control.
  • Shippers get a highly accurate picture of costs.

Cons

  • Since cost-plus is not a viable long-term pricing model, it could encourage a 3PL to generate costs because each cost carries a specified profit margin.
  • Disagreements on what constitutes a cost can arise.
  • Budgeting is more difficult for the shipper because the only constant is the mark up.

Gainsharing and benchmarking
Regardless of the pricing structure, some form of incentive for continuous improvement is advisable. Gainsharing works best with new relationships where the learning curve is highest and opportunities to work smarter abound. This does not preclude using gainsharing as an incentive for a long-standing relationship. Opportunities to drive improvement will always exist, but there is a point of diminishing returns with gainsharing.

Benchmarking, like gainsharing, identifies key performance indicators or areas where improvement is desirable, and rewards those improvements or exceptional performance.

Each outsourcing contract is unique, and equitable pricing is only part of the contract. The resulting pricing structure may use one or more of these pricing models in combination with other performance incentives. Don't try to use the contract negotiation process merely as a chance to slash prices. All too often, companies that win these pricing victories end up losing some productivity and quality in the process.

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February, 2004

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