When procurement professionals are involved in a request for proposal (RFP) process to fulfill a specific business need, one of the most critical factors in structuring the vendor contract with vendors is the contract duration: long-term or short-term?
Long-term agreements (LTAs) offer buyers some obvious advantages, including:
- Better vendor pricing.
- Hedges against dramatic price increases.
- Savings in resources, time and effort.
- Opportunities to build stronger alliances with strategic vendors.
But LTAs present buyers with some downsides, too, in contrast with short-term contracts:
- Market and pricing volatility can go both ways, and while LTAs offer protection from spikes and increases, they also can limit potential opportunities on the other side.
- An LTA could limit a buyer’s ability to develop alternative supply sources or respond to industry or marketplace changes.
- They lock buyers into agreements that could also lock in any vendor inefficiencies or shortcomings.
Pricing and product/service volatility
The obvious and real advantage of a long-term agreement is that they establish firm prices, preventing unwanted increases. They also give buyers some leverage to negotiate other favorable terms into a contract.
Consideration for price increases
Market forces and inflation—together or in tandem—may cause a vendor’s costs to increase. Given this reality, some vendors may want reassurance or guarantees that maintain the value of the contract if their costs rise.
- Negotiations may include price adjustments pegged to the annual rate of inflation.
- A fixed annual rate-of-increase may be set based on average increases for the supplied product or service. In this scenario, the supplier should be required to submit documentation as evidence of their increasing supply costs.
- Payments may be tied to the specific inflation rate each year, agreeing on a specific inflation index and specific date when prices will change.
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.
Consideration for stable or decreasing prices
Prices don’t always and consistently head upward. With increased efficiencies and other factors, prices for many products and services, including computer hardware, data storage services and a wide range of other technologies, may drop over time.
Buyers should consider this when negotiating the length of every contract, remaining attentive to benefits they could miss out on over a long-term.
The stability of the category provided by the vendor can help buyers determine the value for them of a short-term versus long-term contract.
The impact of innovation and change
For some spend categories, such as office supplies, pricing and options are relatively stable, changing little over time. Others, such as tech products and services, may change rapidly due to innovation. 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 better options, particularly for products and services in innovative, high-growth industries. Business history is filled with once-successful companies that became market leaders and then began resting on their laurels, leading to stagnation that opened the door to new competition. The US auto industry is one example, when the complacency of major manufacturers like GM left them vulnerable to companies like Toyota and Honda.
Before signing an LTA, buyers should consider what potential vendor-partners are doing to stay relevant and competitive in the future.
Is the vendor strategic?
Long-lasting relationships can create benefits for both buyers and sellers by offering stability and reassurance on both sides.
Ideally, that stability and reassurance create an incentive for the supplier to look for ways to add value. However, that may not always happen. As mentioned under innovation and change, sometimes vendors become complacent. Also, pressures to increase revenue may lead some vendors to shift their focus to new business, giving current clients (especially those that are locked into LTAs) less attention.
That’s why it’s imperative to consider LTAs only for vendors that are considered strategic and integral to your business needs and operations. And once the LTA is signed, it’s also important for the buyer to monitor vendor compliance and performance.
To ensure that vendors make efforts not only to perform as expected but to add value, buyers can negotiate some forms of protection into contracts:
- Establish key performance indicators (KPIs) for tracking and monitoring how well (or poorly) the vendor is executing its contractual obligations, with commitments to continuous improvement.
- Write an early termination clause into the contract for added insurance.
As buyers gain data and insights over the term of the contract, they can use what they’ve learned to collaborate on ways to improve the relationship.
These are some basic considerations in viewing long-term contracts (generally 3-5 years) versus short-term contracts, which are usually annual. With pros and cons on both sides, it’s important to fully understand both arrangements in the context of the specific product or service, the overall market and industry landscape, vendor profiles and most critically, your business objectives and strategies.