Contract changes could stop 3PL "savings leakage"

They may not know it by name, but most users of third-party logistics services are familiar with the concept of "savings leakage." In the outsourcing world, the term refers to the phenomenon in which a customer sees dazzling returns in the first or second year of its contract only to see the savings slow to a trickle later on, according to Kate Vitasek, a consultant with Bellevue, Wash.-based Supply Chain Visions.

"In essence, you negotiate a deal and then you don't realize the savings that you thought you would over time," she explains.

The reason is pretty obvious. The biggest savings come in year one as the service provider assumes labor and asset costs, and focuses on the projects that will deliver the greatest returns. "In the first year, [the contractor] comes to the table with a different solution, whether it be dollar savings, productivity savings, or re-engineering the network by taking assets out of the network or putting resources into it," says Will O'Shea of 3PD, a third-party logistics service provider (3PL) that specializes in last-mile logistics and delivery services. After that, the relationship settles into more of a maintenance mode. "It's unreasonable for any shipper going into a relationship to expect the same year-over-year savings," O'Shea says.

That's not to say companies can't expect to see year-over-year savings later on in the relationship. But it takes some effort. The customer must be willing to roll up its sleeves and work with the service provider to find new tools, methodologies, and process improvements, says Tony Zasimovich, vice president of global international logistics services at the 3PL APL Logistics.

Oftentimes, however, customers don't make that effort. Once the outsourcing arrangement is up and running, they start focusing their attention and energies elsewhere. Only later do they realize that although the contractor has done exactly what it promised to do, the savings have dropped off.

It doesn't have to be that way, says Vitasek. It's possible to keep the momentum going beyond the second or third year. But it takes some work on the shipper's part, she says. In fact, fixing the problem requires nothing less than rethinking its relationship with the 3PL and the way it contracts for services.

Results, not activities
Before you can address the problem of savings leakage, you have to understand the cause. In many cases, Vitasek says, the problem lies with the original service contract. Traditionally, shippers have structured their outsourcing arrangements around activities—that is, they draft contracts that focus on specific tasks to be performed and compensate the 3PL accordingly. For example, "We will pay you a dollar to pick a product, a dollar per month to store it, a dollar to pack it, and 10 cents for each label."

The problem is, there's no incentive for the 3PL to make the business more efficient—which often involves eliminating activities. In other words, if you're paying the provider on the basis of pallets of inventory stored, the contractor is hardly going to suggest ways to reduce that inventory.

A better approach, says Vitasek, is to contract for—and pay for—results. That is, structure the agreement so that the 3PL gets paid not for storing 1,000 pallets but for reducing the total cost of distribution by 3 percent, or for achieving 99 percent compliance with Wal-Mart's routing guidelines.

This concept of paying for results is known as performance-based outsourcing, or vested outsourcing. The approach originated with the Department of Defense. Vitasek and others are now trying to apply it in the private sector. (Vitasek has a book coming out this month on making that transition, called Vested Outsourcing: Five Rules That Will Transform Outsourcing.)

Although the movement is relatively new, a few 3PLs have already adopted this approach, according to Vitasek. One example is Unipart, a 3PL that provides automotive parts service for Jaguar in more than 60 countries. Unipart is involved in almost all aspects of its customer's business, from the development and launch of new models through aftermarket support, and is privy to such confidential information as Jaguar's vision, business plan, and strategies for specific markets. Richard MacLaren, general manager for Unipart Logistics North America, says the two companies have a "shared destiny."

It takes time
Creating this sense of shared destiny is not easy. According to MacLaren, you can't expect to achieve this type of rapport in the first three years of a business relationship, even if you set out with that goal in mind. Although Unipart aims to develop long-term partnerships with its customers, all of its business relationships start off at a transactional level. Then, says MacLaren, you move on to offering the customer practical suggestions for improvements before developing a business partnership. "You have to get to know each other first," he says.

Adrian Gonzalez, director of logistics viewpoints for the consultancy ARC Advisory Group, agrees that performance-based outsourcing is a long journey. He says the "sweet spot" is usually the fourth or fifth year of the arrangement, by which time the two companies have developed a good working relationship and are starting to develop synergies.

It may require some patience, but building long-term partnerships is worth the effort, adds MacLaren. These relationships foster the type of innovation and creativity that propels companies out of the financial doldrums and onto the global stage.