Identifying Procurement Contract Risk

Supply Chain Case Study on, 

“Identifying Contract Risk and Contingency Planning”

by Jimmy Alyea

This case study’s thesis is that “the Defense Supply Center Columbus (DSCC) was justified in terminating for default an indefinite-delivery purchase order (IDPO) contract at a firm fixed price (FFP) when New Era Contract Sales (New Era) failed to supply coupling tubes as required by a June 29, 2006, delivery order.

Contract performance. 

When New Era, a government contractor, made delivery on a July 6, 2004, IDPO received from DSCC for coupling tubes, a contract was formed.  The contract obligated New Era to supply parts for two years at a firm fixed price.  New Era’s pricing to DSCC was based on a two-year quote from its supplier, Harrison.  New Era’s contract with DSCC contained a standard supply contract default clause but no price adjustment clause.

When New Era received DSCC’s second IDPO on June 30, 2006, it found that Harrison had been sold and its new owner would not honor the original price quote.  On July 5, 2006, New Era asked DSCC to cancel its contract with no liability for either party because its supplier refused to honor the quoted pricing due to an increase in material costs.  When DSCC refused, New Era asked to negotiate a new price based on a new supplier’s higher price quote.  DSCC again refused and terminated the contract for default when New Era did not fill the order.  New Era appealed the decision to the Armed Services Board of Contract Appeals (ASBCA) based on the provisions of the default clause, Federal Acquisition Regulation (FAR) 52.249-8.

           

FAR 52.249-8.   

The clause stated DSCC’s default contract rights but provided an exception for contractor liability if the following occurred: “If the failure to perform is caused by the default of a subcontractor at any tier, and if the cause of the default is beyond the control of both the Contractor and subcontractor, and without the fault or negligence of either . . . .unless the subcontracted supplies or services were obtainable from other sources in sufficient time for the Contractor to meet the required delivery schedule.”

New Era’s opposing view of the thesis. 

New Era believes that its nonperformance is excusable under FAR 52.249-8.  The refusal of its subcontractor’s new owner to honor the original price quoted to New Era was “beyond its [New Era’s] control and without its fault or negligence.”  Similarly, the subcontractor’s refusal to perform was also “beyond its [the subcontractor’s] control and without its fault or negligence” because Harrison had quoted an unusually low price two years ago and because the present cost of titanium had increased dramatically.  As a result, New Era’s subcontractor would have only been able to supply product from its distributor at a cost/unit of more than three times the original contract price.  New Era states that as a small business owner, it could not absorb the resulting $23,904.66 loss.

New Era also asserts that it had taken “all reasonable action” to perform the contract by looking for alternative sources from which to obtain the product in time to meet the contract delivery date.  However, since none of these alternative suppliers carried stock of the needed item and produced only on an “as-needed basis,” this option would not have enabled New Era to deliver in a timely manner.  Although DSCC offered to extend the delivery date in exchange for a $510.18 contract price reduction, New Era believed it should not have had to incur this extra cost because DSCC did not respond for eight months to New Era’s request to cancel the contract without liability because it could not perform.

Because these unforeseen circumstances regarding pricing and product availability were beyond its control, New Era asserts that it was not negligent in its nonperformance of DSCC’s June 29, 2006, order and should be discharged without liability from its contract with DSCC. 

DSCC’s supporting view of the thesis. 

New Era entered into a binding IDPO contact when it fulfilled DSCC’s July 6, 2004 delivery order, obligating itself to honor the offered prices for two years.  As the FFP contract contained no price adjustment clause, New Era accepted the risk of increased prices from its subcontractor.  Thus, New Era’s claim that a price increase was beyond both it and its subcontractor’s control was not a basis on which to abandon performance under the contract’s default clause.  New Era and its subcontractor did not take “all reasonable action” to perform because they could have provided the ordered parts, even though at a loss.

DSCC seeks affirmation from ASBCA of its decision to terminate New Era’s contract for default and to recover costs from having to reprocure from a new source.  The Board found New Era in default of the contract and affirmed DSCC’s actions and request for reimbursement for additional procurement costs.  The Board stated that renegotiating a contract because of a supplier’s price increase would defeat the purpose of a firm-fixed-price contract, which was to protect DSCC from price variations.  It also noted that DSCC had grounds for termination when New Era notified it on July 5, 2006, that it could not make delivery on DSCC’s second order. 

Implications. 

Lessons for contract managers include the importance of protecting against contract risk and of making contingency plans.  New Era should have taken the time to understand the contract terms, particularly the implications of filling the first order of an IDPO contract at a FFP, as well as the consequences of default and the lack of a price escalation clause.   It should have also locked its supplier into a contractual agreement as to pricing and the subcontractor’s liability for default, instead of depending solely upon a price quote.  New Era would have ultimately been better off had it performed the contract at a loss and then brought suit against its supplier.  Good advice for contract managers would be to expect the best but plan for the worse, and when in doubt, seek legal advice quickly before a problem escalates.

Copyright 2012 James L. Alyea. All Rights Reserved.

About Jimmy Alyea:

Jimmy Alyea lives in Houston, Texas, and holds two Bachelor of Business Administration degrees (Supply Chain Management and Marketing) and a Master of Business Administration degree.  Follow Jimmy Alyea (James L. Alyea) on LinkedIn, Twitter, or Blog.

Case Study Reference:

“IDENTIFYING CONTRACT RISK AND CONTINGENCY PLANNING” by Jack Horan, Contract Management, Aug., 2009. Retrieved from http://www.mckennalong.com/media/site_files/1140_August%202009.pdf

E-Business Distribution Networks

How Amazon has used its distribution system in e-business, and general features of e-business distribution networks

by Jimmy Alyea

Distribution systems have been used in e-business to improve customer service in terms of access, customization, and convenience and to lower costs in supply chains.  For example, Amazon.com has lower inventory and facility costs due to their use of e-business for sales rather than bricks-and-mortar retail stores, but their transportation costs are high because they must ship books to customers. Shipping costs are a big portion of their book costs.  However, inventory costs are low compared to retail stores because Amazon.com is able to aggregate inventory in a few geographical locations.  They keep mainly medium- to high-demand books in their own warehouses and purchase low-demand books from a distributor when a customer orders.  This reduces inventory costs considerably, but their facility costs are growing since business is increasing and they have had to add warehouses. 

In the customer-service area, customer experience is very positive in terms of access, customization, and convenience.  Customers, however, must be willing to wait for delivery of books they have ordered unless products can be downloaded.  Benefits to customers also include better order visibility and quicker access to new products.

Basic features of an e-business distribution network include low facility and inventory costs but high transportation costs.  An e-business can carry a wide variety of products, but response times are longer than those at retail stores, excluding products that can be downloaded.  In terms of product availability, e-businesses communicate customer demand information throughout the supply chain faster, so their forecasts are much more accurate.  Also, they can launch new products faster by shipping directly to the customer instead of having to first stock retail shelves.  Overall, the customer experience is very personal due to access, customization, and convenience of online shopping.

Copyright 2012 James L. Alyea. All Rights Reserved.

About Jimmy Alyea:

Jimmy Alyea lives in Houston, Texas, and holds two Bachelor of Business Administration degrees (Supply Chain Management and Marketing) and a Master of Business Administration degree.  Follow Jimmy Alyea (James L. Alyea) on LinkedIn, Twitter, or Blog.

The Pros and Cons of Outsourcing in Supply Chain Management

The Pros and Cons of Outsourcing in Supply Chain Management

by Jimmy Alyea

 “Outsourcing,” the practice of one firm hiring another to perform tasks that were originally performed in-house, is often viewed a way of maintaining or increasing a firm’s competitiveness.  With a general goal of lowering costs and/or streamlining workflow, a firm is able to concentrate on strengthening its core competencies.   Others view outsourcing, both domestically and internationally, in a negative light, questioning its effect on America’s workforce and economy.  Weidenbaum’s emphasis in the above-titled 2005 article is on the pros and cons of the overseas outsourcing of the activities of a firm, which has become a controversial issue in the U.S. and is becoming more so in light of the upcoming 2012 presidential election.

           

Why companies began outsourcing.  

Many service companies began creating jobs abroad to gain access to overseas markets, many of which have grown quickly, while some domestic markets have become mature, if not saturated.  For example, approximately 60 percent of the revenue of American information technology markets originates overseas.  Leading firms in various industries, such as banking and consumer products, report that their foreign revenues exceed those of their domestic sales.  U.S. companies also began hiring specialized workers overseas in response to U.S. immigration limits that hindered their ability to find qualified workers, particularly in science and engineering.  In so doing, many companies became accustomed to using modern technology to shift the location of work, as well as to the benefits of lower operating costs and pay scales in foreign countries.  Additionally, telecommuting paved the way to extend the process of shifting work to new suppliers, both at home and abroad.  Overseas outsourcing has accelerated in recent years due to globalization and to technological changes, primarily in the telecommunications and transportation sectors.

Advantages of outsourcing. 

Fundamentally, businesses that outsource are able to focus resources on core business processes in order to operate efficiently in an increasingly competitive global marketplace.  Expertise can often be acquired at a lower cost than hiring in-house when tasks are outsourced to vendors with special equipment and knowledge.  In addition, outsourcing certain parts of a company’s business process to a specialist facilitates risk-sharing and better analysis of risk-mitigating strategies.  Cost reductions can generate new market opportunities for U.S. companies and thus generate additional jobs domestically.   Large software companies such as Microsoft and Oracle have simultaneously increased outsourcing and their domestic payrolls.  Other advantages include the ability to provide constant coverage for consumers who require 24-hour support, especially when foreign and domestic competitors are doing so.

Limits and dangers of outsourcing. 

Companies who join the “outsourcing” bandwagon may be surprised by unexpected costs and complications, particularly in the overseas arena.  Research reveals that almost one-half of outsourcing agreements end up being terminated for a variety of reasons (Lutchen, 2004).  Some overseas vendors encounter financial difficulties or are acquired by firms with different procedures and priorities.  Unreliable suppliers may put current work aside when a more important client is gained, or they may have rapid turnover of skilled employees who find jobs with more desirable firms.  Typical Indian operations in business processing often lose 15 to 20 percent of their workforce annually.  Moreover, overseas managers often do not understand American business practices such as high quality-control and expectations for prompt delivery of goods and performance of services.  Dell, for example, moved its customer-support call center back to the U.S. in 2003 after consumers revolted against receiving vague, hard-to-understand answers to technical questions from non-native English speakers (Morphy, 2006).  Boeing’s 2007 scheduled release of its 787 Dreamliner aircraft was delayed more than three years by problems caused by a complex supply chain of over 50 global suppliers and a splintered international engineering team (Peterson, 2011).

U.S. firms may also encounter a variety of unanticipated difficulties in foreign nations such as arcane legal systems, theft of intellectual property, requirements of tax and regulatory agencies, and political upheavals such as the riots that accompanied the overthrow of Indonesia’s president in 1998.  Furthermore, they may encounter corrupt officials in the public sector.  In the mid-1990s, officials of a Halliburton subsidiary were involved in a Nigerian joint venture project that resulted in a decades-long bribery scheme to secure contracts in Nigeria (Olorunyomi & Mojeed, 2009).  Other costly complications and hidden costs may arise such as a lack of reliable sources of electricity, transportation networks that need to be upgraded, or business customs that must be observed.

Net effect on the U. S. 

Over the years, far more new jobs have been created in the U.S. than have been outsourced.  The current debate on overseas outsourcing frequently focuses on short-term job losses  in industries such manufacturing, while ignoring long-term benefits to consumers and businesses.   Outsourcing helps companies stay competitive, resulting in more investment and, in turn, the creation of new or better jobs.   In the long run,  outsourcing is not a zero sum game, but rather one where net gains are positive.

Copyright 2012 James L. Alyea. All Rights Reserved.

References:

Introduction to the outsourcing & offshoring industry. (2011).  Plunkett Research, Ltd.  Retrieved from http://www.plunkettresearch.com/outsourcing-offshoring-bpo-market-research/industry-overview

Lutchen, M. D. (2004, May).  Outsourcing IT headaches is no answer.  Chief Executive.  Retrieved from  www.thefreelibrary.com/Outsourcing+IT+headaches+is+no...

Morphy, E. (2006, January 30).  Dell pumps up Indian outsourcing operations.  CRM Buyer. Retrieved from http://www.crmbuyer.com/story8579.html

Olorunyomi, D. & Mojeed, M. (2009, May 1).  The Halliburton bribe takers.  234next.com. Retrieved from http://234next.com/csp/cms/sites/Next/News/5395403-147/The_ Halliburton_bribe_takers_.csp#

Peterson, K. (2011, January).  A wing and a prayer:  outsourcing at Boeing.  Reuters.  Retrieved from http://graphics.thomsonreuters.com/11/01/Boeing.pdf

Weidenbaum, M. (2005,  July-August).  Outsourcing:  pros and cons.  Business Horizons.  Retrieved from hbr.org/product/outsourcing-pros-and-cons/an/BH127-PDF-ENG

About Jimmy Alyea:

Jimmy Alyea lives in Houston, Texas, and holds two Bachelor of Business Administration degrees (Supply Chain Management and Marketing) and a Master of Business Administration degree.  Follow Jimmy Alyea (James L.Alyea) on LinkedIn, Twitter, or Blog.

Supply Chain Analysis of Why Nissan’s Disaster Recovery Bested Rivals

Supply Chain Analysis of, “Why Nissan’s Disaster Recovery Bested Rivals”

by Jimmy Alyea

The “Big Three” automakers in Japan--Toyota, Honda, and Nissan--all suffered immensely from the devastating earthquake and tsunami that struck northern Japan on March 11, 2011.  Although most Japanese automakers did not see their factories heavily damaged, most were forced to halt a large portion of their production, both inside and outside Japan, when deliveries of hundreds of parts from the country’s devastated northeast were cut off.   Followed by the widespread November flooding in Thailand that impacted numerous assembly and component manufacturing companies, the disruption to the industry’s complex automotive supply chain has spread well beyond Japan’s borders.  These natural disasters wreaked havoc on the bottom lines of auto giants Toyota, the world’s largest automaker and Japan’s biggest company, and Honda, Japan’s fourth largest company.  However, Nissan, the perennial “also-ran” of the Big Three, has overcome the crisis much quicker and gained market share at the expense of its two most acclaimed rivals.

As industry analysts tracked recovery during the following months, they noted that Nissan fared better and more effectively than Toyota and Honda.  No one action by Nissan’s management stands out as a determining factor in its successful recovery during the past year, but rather a series of deft moves set Nissan apart from its rivals almost from the outset of the twin catastrophes.  Almost immediately after feeling the effects of the earthquake at its Yokohama headquarters, Nissan key executives gathered for a crisis management meeting.  Teams were quickly dispatched to different Nissan outlets to help the company determine which Nissan models would be most affected by the disaster (Curtis, 2011).  Additionally, within a week, Nissan’s CEO Carlos Ghosn was on television decisively assessing the damage at one of Nissan’s two severely damaged engine plants and telling reporters precisely when the plant would reopen.  Although Ghosn’s comments most likely served to stir local authorities into action, such transparency is rarely seen in Japan’s corporate world.

Analyst Rebecca Lindland of HIS/Global Insight pointed out that unlike its competitors, Nissan “got its assembly plants and suppliers up and running sooner.”  Nissan benefitted greatly from its standardizing parts worldwide and from its strategy of using common parts such as its low cost, V-platform for vehicles in emerging markets.  Lindland also commented that Honda was hampered in restarting production because although it had two first-tier suppliers, both sources were hit by the same shortage of materials (Levin, 2011).  Even Toyota noted that Nissan seems to have been less affected than its major rivals.  As pointed out in a recent Wall Street Journal article, a senior Toyota executive made the statement that the auto giant could “learn a thing or two from Nissan’s handling of [supply chain] disruptions in Thailand. . . ” (Simms, 2011).  Such a compliment is unprecedented in a culture that goes to great lengths not to praise or criticize peers, much less fierce rivals.  A writer for Procurement Leaders responded by commenting, “. . . but the compliments are well deserved and should have been extended to how Nissan handled the Japan quake, after which it restarted production months before its rivals” (Rae, 2011).

Other factors cited by industry analysts that have worked in Nissan’s favor during the crisis include the fact Nissan’s corporate organization is structured differently from that of Toyota and Honda, whose boardrooms are exclusively Japanese.  With Brazilian-Lebanese-French businessman Carlos Ghosn as CEO and several foreign-born executives on Nissan’s board, including British-born Colin Dodge, Nissan’s Chief Recovery Officer after the post-Lehman financial world, Nissan’s crisis management team appeared more streetwise and quick-thinking than that of its major rivals.  A top spokesman at Nissan’s Yokohama headquarters stated that one of Nissan’s strengths that helped meet the disaster challenges so successfully was the company’s working together cross-functionally for quick and focused recovery actions.

 Nissan, also supplemented with a strong portfolio of products and the advantage of broad, efficient global “monozukuri,” (a Japanese word that means manufacturing), has managed to outdo its rivals in dealing with the catastrophic adversities of 2011.  However, Nissan cannot count on Toyota and Honda floundering forever.  As Levin (2011) succinctly summarized,  “being the underdog was easy.  Maintaining the lead—that’s the hard part.”

Copyright 2012 James L. Alyea. All Rights Reserved.

References:

Curtis, M. (2011, December 23). It has been a test to how fast Japanese automaker Nissan to

escape disaster. Auto-Types.  Retrieved from http://www.auto-types.com/autonews/it-has-been-a-test-to-how-fast-japanese-automaker-nissan-to-escape-disaster-8100.html

DeAngelis, S. (2011, August 5). Supply chain recovery from Japan’s earthquake/tsunami:  an update. Entera Insights.  Retrieved from http://enterpriseresilienceblog.typepad.com/enterprise_resilience_man/2011/08/supply-chain-recovery-from-japans-earthquaketsunami-an-update.html

Koploy, M. (2011, July 15). The pst-tsunami supply chain all-stars.  Software Advice.  Retrieved from http://blog.softwareadvice.com/articles/scm/post-tsunami-supply-chain-all-stars-1071511/

Levin, D. (2011, August 23). How Nissan zoomed to the front of the pack.  Fortune Tech.  Retrieved from http://tech.fortune.cnn.com/2011/08/23/how-nissan-zoomed-to-the-front-of-the-pack/

Nunn, P. (2011, December 5). Why Nissan’s disaster recovery bested rivals. AutoObserver.com.  Retrieved from http://www.autoobserver.com/2011/12/why-nissans-disaster-recovery-bested-rivals.html

Rae, D. (2011, November 18). What’s the ROI of risk management?  Just ask Nissan.  Procurement Leaders blog. Retrieved from http://blog.procurementleaders.com/procurement-blog/2011/11/18/whats-the-roi-of-risk-management-just-ask-nissan.html

Simms, J (2011, November 18).  Nissan’s fast responders.  Wall Street Journal.  Retrieved from http://online.wsj.com/article/SB10001424052970203611404577043430305932926.html

 

About Jimmy Alyea:

Jimmy Alyea lives in Houston, Texas, and holds two Bachelor of Business Administration degrees (Supply Chain Management and Marketing) and a Master of Business Administration degree.  Follow Jimmy Alyea (James L. Alyea) on LinkedIn, Twitter, or Blog.