The fallacy of Long-Term Agreements OR how not to buy a car.
For those lucky enough to have had careers in the automotive industry, Long-Term Agreements (LTAs) are as common as cars themselves. Most consider them a normal part of doing business. They are meant to provide suppliers with assurances of volumes over the full life of the program in exchange for steady supply and cost reductions for the customers. It’s standard practice for the suppliers to offer customers LTAs in the form of annual price reductions (or rebates) over program life and/or an upfront lump sum payment before the start of production (SOP). The larger the price decreases or lump sum payments, the better for the customers. The supplier sales team is happy to win the business, and the customer purchasing team is happy to bring savings to their company every year. Except that none of it is real.
Here is the reality for each type of LTA:
Annual price reductions (sometimes called productivity)
Imagine going to a dealership to buy a car for $30,000 and the salesperson says, “Hey, I have a great deal for you today. How about you pay $39,000 for the car, but I’ll send you a check for $3,000 every year for the next three years?” That’s productivity in a nutshell.
Since suppliers are required to start production at high efficiency and cannot increase their actual productivity much over time (changes in the manufacturing process require customer approvals), the only way for them to offer price reductions to their customers is to increase their upfront price. Thus, in essence, customers are allowing their suppliers to hold the money for them and give it back to them over time.
This is nonsensical, especially when interest rates are high because suppliers can earn interest on the money they hold for their customers. This practice does not benefit customers’ bottom lines, as they lose out on potential interest. Suppliers’ price reductions are not real savings. In fact, they increase the customer’s cost, just like a person buying a car at a higher price.
Annual rebates
Now, imagine your spouse sending you shopping for a car with a $30,000 budget, and you happen to negotiate a lower price of $27,000. However, the salesperson suggests they charge you $30,000 and then give you $3,000 in cash the following year without your spouse knowing anything about it. That’s rebates in a nutshell.
Essentially, the customer pays a higher price, and the supplier gives the customer a lump sum payment every year as reimbursement for that higher price. Just like the annual price reductions, the customer loses interest earning potential on the money held by the supplier. Again, although purchasing departments count these rebates as annual savings, they are not real savings for the company. In fact, they increase the customer’s cost.
Lump sum payments
Finally, imagine buying a car for $30,000 but then asking the dealership for a $3,000 loan on top, which would be paid back in monthly payments for the rest of the loan. That’s lump sum payments in a nutshell.
Essentially, the customer is taking a loan from the supplier to be paid back in a higher piece price over the program life. Since most suppliers don’t have cash lying around to give out to customers, they borrow money from a bank and also have to pay interest on that loan, which, in turn, they charge their customers. They can choose to charge their customers only what they pay the bank, or they can charge their customers higher rates to pay for their administration of the loan or even to make a profit from it.
This is not beneficial to the customer, since they may be able to borrow money from a bank directly, probably at lower interest rates. That is, if they require a loan at all. Thus, even though lump sum payments are claimed by purchasing departments as annual savings, they are, in fact, increases in cost to the customer.
In summary, just like buying a car at prices that are higher than necessary, it is not beneficial for customers to engage in the practice of buying products with LTAs. While LTAs were once considered a way to provide contract security to suppliers and customers, they became a masquerade of bad business practices. Instead of providing guarantees of business over program life in exchange for upfront lump sum payments or future price reductions, the customers are only guaranteed to pay more than is required.
Even the suppliers do not benefit in the end. Although they can earn interest on customers’ money, customers tend to ask for more and more money over time as they try to squeeze the suppliers. Managing these demands can become costly and burdensome.
More sales reps, buyers, and accountants are needed to administer the complexities of the whole scheme at both suppliers and customers. This is an additional cost to every company that’s usually forgotten as it is buried in a company’s SG&A.
Thus, in the end, neither customers nor suppliers benefit from the LTAs except to report fake annual cost savings achieved (by the customer’s purchasing team) or minimized annual givebacks achieved (by the supplier’s sales team). There is no tangible benefit to the companies besides career advancement for those who excel at playing the LTA game.
To learn more about proper cost and profitability management, research many educational materials available through the Society of Product Cost Engineering and Analytics (SPCEA) and the Profitability Analytics Center of Excellence (PACE). The expertise in cost and profit management can also be certified by SPCEA (CPCE certification is available online and on-demand through its website at spcea.org), giving employers the certainty needed in their cost and profit calculations.
Written by Chris Domanski, author of “Cost Engineering” and “The Cost.”