Problems that surface in logistics outsourcing deals often revolve around a few specific areas. And most often found at the top of a list of difficulties are information system (IS) dilemmas.When technology is handed from a customer to a third-party logistics provider it can often handcuff a company in the beginning. Vendors promise a more efficient running warehouse and speedier deliveries after implementation or integration of new technology, but what isn’t always promised is a speedy installation. And often even if there is a promised installation deadline, it often passes like the wind as system bugs infiltrate the systems and cause nightmarish delays. Attorney Richard Raysman of Brown Raysman Millstein Felder and Steiner in New York, mentions the Denver International Airport debacle as a prime example of what can happen.
Slated for an opening in October 1993, the airport sat empty for 16 months after construction was completed, finally opening to skeptical travelers on Feb. 28, 1995. The airport was to be the eighth wonder of the world. It was touted as an airport twice as big as Manhattan and a marvel of modern engineering. But a system of 5,000 electric eyes, 400 radio receivers, 100 computers and 56 bar code scanners was not working properly. The system controlled 21 miles of track that routed baggage through an underground cavern that connected the gates, counters and claim areas of over 20 airlines. As investors waited almost a year and a half for the glitches to be worked out they swam in a sea of red ink that was swallowing them up at the tune of $1.1 million a day in interest alone.
Though not on this scale, IS problems are common. According to Scientific American, for every six large-scale software systems that are put into action, two others go south. Raysman says that it often has to do with interface issues. The meshing of different software programs can lead to problems.
“There is not one software product that can handle all the complexities of an entire warehouse,” Raysman says. “There are a list of programs including inventory programs, weight programs and packaging programs, and the interface between these esoteric programs can cause difficulties.”
It is often a challenge to get these systems implemented and it can be quite frustrating for the customer who has to wait it out. Sometimes when a logistics outsourcer takes over warehousing operations they have to reengineer an already existing warehouse, but a lot of times an entirely new warehouse is built and then outfitted with technology. “And if unexpected delays go on for three or six or nine months before a warehouse can actually be put into use, there can be quite a serious loss to the customer,” he says.
Working Out Service Levels
Other problems involve service levels, which is not unique to logistics. Raysman says that service levels in logistics outsourcing involve loss and damage issues, and product delivery specifications.
Raysman notes that there are no legal restrictions on the penalties that can be accessed to vendors for service levels not reached. There are certain laws in place, but the parties are committed by a contract that overrides existing laws on penalties. So the penalties can be whatever the sides agree upon. These types of contracts usually state that once the product is handed off to the logistics supplier the responsibility of losses or damages remains with the supplier until the product is dropped off at its final destination. Even if the product is lost or damaged during fortuitous circumstances like an explosion or a train derailment, which has nothing to do with negligence, it is still the supplier’s liability. But even if this is agreed upon and the logistics outsourcer accepts the replacement value, the customer pays in the end because the outsourcer buys insurance and passes the cost of that onto the customer.
Raysman says that there is sometimes a certain amount of nominal loss that is built into the agreement, which means the vendor is covered up to a specified dollar amount for damaged or lost products. Customers may look at their own loss and damage experiences in the past and use them as a baseline for the third-party provider. “The vendor gets, for example, the first $100,000 a year, and the customer will eat that amount.” Raysman says. “Anything that is lost or damaged over and above that would then be allocated to the vendor.”
Applying Performance Credits
There are also other acceptable penalties, termed “performance credits,” which a customer can receive from a vendor for delayed shipments, he says. If the shipment isn’t delivered within the agreed upon time frame there will be a credit of some amount and those amounts are negotiable against future payments. Performance credits can be negotiated into the contracts.
Because of the complexity of the numerous service level agreements, Raysman argues that logistic outsourcing contracts are among the hardest to write. “Logistics is such a key element of a customer’s business and can make negotiations difficult,” he says. “Customers are very nervous about handing over full control of shipping and warehousing to an outside vendor.”
From the vendor’s point of a view there are certain absolute requirements that must be in the contract. These include pricing, algorithms, the limitation of liability arrangement, and protection of proprietary rights for intellectual property that the vendor brings to the table. From the supplier’s point of view they have to understand the pricing. Raysman says that it is surprising how often pricing algorithms are not understood by the supplier and the vendor. The other complex part is allocation of risk of loss, he says. It has to be made perfectly clear when the risk of loss passes from the customer to the supplier and when it is handed back from the supplier to either the customer or the final destination. “There really has to be full discussion and a meeting of the minds as to how all of this works,” he says, “and it tends to be tricky, but not impossible.”