Note: This article was originally published on September 30, 2019 and has been updated with insights from LAC Group’s Procurement Strategy Advisor, Bill Wallack.
An important contract renewal consideration is the duration: should you negotiate a long-term or short-term agreement?
Short-term agreements tend to be contracts with annual renewals. Historically, long-term contracts have been three years, and in rare cases, possibly five with the option to terminate earlier without penalty.
As a procurement professional with years of experience in both manufacturing and service companies, I will touch on some of the best practices and conventional wisdom on long-term agreements.
Table of Contents
Advantages of long-term agreements (LTAs)
Going long can be summarized in three primary benefits to buyers:
- Better pricing and/or hedges against dramatic price increases.
- Opportunities to build stronger alliances with strategic suppliers.
- Savings of time and effort spent on research and negotiation for annual contracts.
Given these advantages, it’s still important for buyers to assess the supplier landscape and market stability for the indirect materials and services they procure. Buyers should also understand their leverage points and purchasing power, as this will determine their ability to negotiate the most favorable terms.
When determining short-term versus long-term contracts, no one-size-fits-all rule applies.
Pricing and market volatility
The primary advantage of an LTA is that it establishes firm prices, providing stability and greater control over business planning and budgeting processes. Whether prices trend upward or downward, LTAs can help a buyer take advantage of those dynamics through risk mitigation language.
Yet suppliers and their suppliers are also savvy about protecting their own interests. Market forces and inflation—together or in tandem—may cause their costs to increase. Given this reality, suppliers may want reassurance or guarantees to maintain the value of the contract.
Generally these assurances take two forms:
- Fixed annual rate-of-increase based on average increases—in this scenario, suppliers should be required to submit documentation as evidence of their increasing costs.
- Price adjustments pegged to the annual rate of inflation, with agreement on a particular index like the consumer price index (CPI), wholesale price index (WPI) or commodity-specific indexes.
In addition, buyers should be aware that suppliers may want to include a clause that allows for a cost of living adjustment (COLA) in a multi-year contract. Such adjustments can be capped to a percentage of such increases or outright avoided based on volume and other business considerations.
On the flip side, stable or decreasing prices also warrant consideration as prices don’t always head upward. This happens frequently in technology, when increased efficiencies and competition come into play. Pricing for many products and services may drop over time, which buyers should consider when negotiating the duration of a contract. Establishing a cost benchmark which ties technology decreases to the price paid is key, along with quarterly business reviews to status such declines and agree on new pricing.
Innovation impact on pricing
For some indirect spend categories, such as office supplies, pricing and options are relatively stable. Yet as I just mentioned, some categories like information technology may change rapidly due to innovation and mergers and acquisitions. A multi-year contract, if not negotiated carefully, could end up being a liability by taking away a buyer’s flexibility to respond to these changes and evaluate alternatives. For example, after committing to a multi-year agreement with a software company, a newer solution with a better fit may emerge or a competitor that wants the business may offer more attractive pricing and terms.
Buyers who consider only the dollar benefits of multi-year contracts assume a range of risks if their contract keeps them from adopting newer and better options, particularly for products and services in innovative, high-growth industries. While LTAs can offer some price protection, they also can limit a buyer’s ability to develop alternative supply sources or respond to industry or marketplace changes. They can lock buyers into agreements that could be detrimental in the event of supplier shortcomings and inefficiencies. Where applicable, buyers should have the right to early termination with penalty, if possible, to assure maximum flexibility when there is a chance of a technology move.
Business history is filled with examples of companies and even industries that began resting on their laurels, becoming stagnant and complacent as a result. Before agreeing to an LTA, buyers should consider what suppliers are doing and planning to remain relevant and competitive.
Strong and strategic supplier relationships
LTAs can be most beneficial with strategic and valued suppliers. Long-lasting relationships create benefits by offering stability and reassurance on both sides. Ideally, this creates an incentive for the supplier to look for ways to add value and align more strongly with the buyer’s business goals and objectives.
However, that may not always happen. As mentioned under innovation and change, sometimes suppliers become complacent. Also, pressures to increase revenue or grow market share may lead some suppliers to shift their focus to new business, giving current clients (especially those that are locked into LTAs) less attention. It is important that companies advocate for quarterly business reviews to give attention to the full scope of the mutual relationship.
That’s why it’s imperative to consider LTAs only for suppliers that are considered strategic and integral to your business needs and operations. Buyers can negotiate some forms of protection into contracts, and monitor supplier compliance and performance once the LTA is signed:
- Establish key performance indicators (KPIs) for tracking and monitoring how well (or poorly) the supplier is executing its contractual obligations, with commitments to continuous improvement or paybacks if they’re not met.
- Write an early termination clause into the contract for added insurance.
With the help of data analytics and business intelligence, buyers can use what they experience and learn to collaborate on new ways to improve the relationship.
Procurement research and intelligence
LAC Group is known for research and intelligence services in areas like legal matters and competitive intelligence. We apply that same rigor and expertise to sourcing and procurement. The depth of research that we can perform and the resources we bring to this area are a huge advantage to our spend management clients. We can monitor and uncover news and trends, everything from M&A activity to pricing benchmarks to supplier motivations that affect the pricing, terms and conditions they’re willing to offer.
Common questions buyers have about LTAs
What indirect materials or services should we say yes to in an LTA?
This depends primarily on what you’re buying. Commodities, which might be anything from oil and gas to agricultural products, lend themselves to agreements that could run as long as five to seven years. Some commodities, like natural gas, can yield price predictability by putting together a hedge agreement if volumes warrant this option.
For information technology, a three-year agreement is common for categories like software, which with maintenance for future upgrades, can be favorable on the pricing horizon. When you have a stable and proven supplier, LTAs deliver the predictability of supply and cost.
In what instances should we always go short?
For spend categories with competitive markets and fungible commodities, such as office supplies and maintenance, repairs and operations (MRO) expenses.
With additional years in a contract, what are the additional rewards and risks?
The usual rewards come in the form of protection from market volatility or supply constraints. You should tie additional years to a savings reward, if possible, like guaranteed annual savings targets that the supplier will underwrite, increased discounts for increased purchases, and value-added services, such as:
- Supplier-managed inventory for order management and fulfillment.
- On-site or other dedicated support.
- Procurement data reporting and analytics.
- Early involvement in projects where the supplier has a skill set that will add value.
The additional risks are what I’ve said in terms of locking in possible supplier complacency and shortcomings, and missing out on emerging options that would be a better solution for the underlying business needs.
When renewing, consider those materials or service needs over the next contract horizon based on the business forecast and how these factors have changed from the initial term. Ask yourself, “Is there market volatility or restraints that will cause a disruption to my business which can be minimized by locking in supply and price guarantees?”
What about the possibility of supplier mergers and acquisitions?
M&A activity has become common as small companies are gobbled up by larger, established players. It happens in all sectors, especially technology. Often, existing LTAs are treated as stand-alone obligations that are honored through the contract end, and that possibility should be addressed and defined as part of the LTA. Contracts should contain ‘assignment’ language that would be used if the supplier or the company were sold, requiring written consent from the party not being sold and giving the right to terminate, if applicable, in the face of such an assignment.
What if my organization has limited procurement expertise and staff?
That’s when the benefits of working with spend management experts like LAC Group come into play. We are able to review your category needs and expenditures to offer expert analysis and strategy recommendations. Through data analytics and monitoring of contract performance, our analysts and other support staff can either extend the reach of your internal teams or manage the process for you.
Understand the risks and rewards of LTAs
As I mentioned at the start of this article, LTAs offer three primary benefits in regard to better pricing, stronger and more strategic supplier alliances, and savings in time and effort. LTAs facilitate the budgeting and planning processes and can be used to lock-in favorable pricing in volatile markets. They also facilitate true partnership and relationship-building between supplier and buyer as there is more incentive and time for collaboration. Also, time and resources are reduced when the contract renewals are fewer and farther between.
With pros and cons on both sides, it’s important to fully understand both long-term and short-term arrangements in the context of the specific product or service, the overall market and industry landscape, supplier profiles and most critically, your business objectives and strategies.