The 3PL industry: time to reset

This story first appeared in the Quarter 4/2020 edition of CSCMP’s Supply Chain Quarterly, a journal of thought leadership for the supply chain management profession and a sister publication to AGiLE Business Media’s DC Velocity. 

It is time for the third-party logistics (3PL) industry to reset.

A bold statement for sure. Why do we say this? Among us, we’ve collectively spent over 75 years working on and leading outsourcing deals—mainly in the transportation and logistics industry sector. During that time, we’ve worked directly and indirectly on hundreds of 3PL/client commercial structures and contracts. Based on that wealth of experience, we believe leaders in the 3PL industry—both clients and providers—need to face the sad fact that they are wasting countless hours and millions of dollars in an endless buy-sell tug-of-war. Muscular contracting practices have over-commoditized the industry, making it difficult for much-needed investment and innovation to happen. Simply put, the 3PL industry is falling victim to Gresham’s Law.

Gresham’s Law is an economic principle that states bad money will drive good money out of circulation. We believe there is a “Gresham’s Law” scenario occurring in the 3PL industry. The over-commodification of the industry is driving good 3PLs to become bad ones (or at least mediocre ones) because they are being forced to compete on price instead of innovation. Thus, great 3PLs are finding themselves in an unavoidable race to the bottom to keep up.

Yet, at the same time, many buying organizations want and need 3PLs to innovate and invest in the latest technology—especially for client-centric solutions. However, 3PLs are reluctant to do so, as razor-thin margins and short-term commodity-based contracts create a disincentive for 3PLs to invest. Chief financial officers at 3PLs are—rightfully—unwilling to invest in a client just because it says they have a strategic partnership, as it often turns out to be simply lip service when it comes to the actual contract.

But these innovations are desperately needed for both the 3PLs and their clients to survive in the current business environment—one exacerbated by the pressures that the Covid-19 pandemic is placing on the industry. For this reason, we argue that transactional ways to procure 3PL services are at a tipping point and ripe for change.

THE STRATEGIC PARTNERSHIP MYTH

In the best-selling book The (Honest) Truth About Dishonesty, the highly regarded behavior economist Dan Ariely links harmful business practices and corruption, such as the accounting fraud that occurred at energy company Enron Corp, also known as the Enron Scandal, in the 2000s, to a business culture of white lies and wishful blindness. Far from being an anomaly, Ariely says, this type of culture exists at many companies.

We see parallels in the 3PL industry, where much of the friction and tension between providers and clients stems from the little white lie that the two tell when they call each other “strategic partners.” Simply put, many companies use terms like “partner,” “expert,” and “trust” when referring to their 3PL, but in reality, these concepts often end up feeling like lip service when it comes to the actual contract. Take, for example, the common “termination for convenience” clause. A 60-day termination clause in essence equates to a 60-day window for return on investments. No wonder 3PLs are not investing like they could.

Still worse, there is a trend by buying organizations to shift an extraordinary amount of unreasonable risk to 3PLs by including wildly lopsided and aggressive terms and conditions. Take the concept of liability. We are all for holding a 3PL accountable for issues it causes, but this should be done at a fair level. We have seen many buying organizations demand their 3PL have very high liability caps on indemnification and cargo claims, usually around $5 million or higher. In addition, the liability is being tied to sales value, not just inventory value.

In some very limited cases, true strategic partnerships really do exist. Consider McDonald’s, which was featured in the book Vested: How P&G, McDonald’s and Microsoft Are Redefining Winning in Business Relationships. Most people are surprised to learn that McDonald’s consciously chooses to avoid the “cat-and-mouse game” of bidding in favor of creating deep trusting and transparent relationships with its most successful supply chain partners.

However, McDonald’s is rare. The vast majority of 3PL relationships are built on a backbone of highly transactional commodity procurement processes fostered by a “win-lose” mentality.

The good news is, during the typical 3PL vetting and selection process, many companies do work hard to develop a sense of trust. The most progressive clients take the time to create trust by having a rich dialogue around their supply chain goals and issues. Clients and potential providers talk about innovation, value creation, and the art of the possible.

But then comes the contracting process.

The majority of companies using 3PL providers construct long and detailed operating agreements with prescriptive statements of work backed with penalties linked to service-level agreements (SLAs) for nonperformance. Of course, the intent is good: to drive accountability of 3PL performance. However, University of Tennessee research shows overly detailed statements of work can easily backfire because they create what researchers call “the outsourcing paradox.” The concept is simple: Buying organizations outsource a key scope of work because it is not a core competency or they choose to not make investments in infrastructure and processes. They then turn around and tell their service provider how to do the work in a prescriptive statement of work. By doing so, they are, in essence, contractually obligating their 3PL to maintain the status quo of the way the work is currently done instead of incentivizing them to come up with the best way to do the work.

In addition, procurement teams are trained to “beat down” the provider’s margin as opposed to obtaining the most value for their companies. They typically focus on incremental price reductions, even going so far as to dictate hourly rates, employee benefits, and unplanned cost absorption. This, too, creates an outsourcing paradox. If the buyer really did know best, then the buyer should have kept the work in house!

But are the buyers the only ones to blame. No!

Third-party providers play the buyer-supplier game as well. You rarely hear 3PLs complain about contract structures, pricing, or penalties when their profit margins are high enough to offset potential penalties and the pain of challenging relationships. However, 3PLs are quick to look for contract relief or propose innovative contract structures when margins are below targeted thresholds.

A LONG TALE OF SHORT-SIGHTEDNESS

Let’s look at a real example of how so-called strategic partnerships often work in practice. One of us worked at a 3PL that had a large and profitable client that it worked with for almost 15 years. We, of course, called each other “partners” and said we valued our long-standing and trusting relationship.

But was it really a long-standing and trusting relationship? Not when you factor in the inherent perverse incentives created by conventional commodity thinking coupled with transaction-based contracting practices.

The partnership mentality waxed and waned like the moon through its phases. Like clockwork, the buying organization would engage in a typical request for proposal (RFP) process every five years as part of a requirement to “test the market” and to create “competitive tension.” “Nothing personal, it’s just business” was the typical mantra for each bidding cycle. So, like clockwork, we stepped up to play the game.

Historically, the bidding process had been a mere formality and went something like this: The buying organization would request proposals. We, the incumbent, would submit our proposal alongside our competitors. Later, each of the bidders would be invited to present its solution and pricing. Ultimately, we, the incumbent, would sharpen our pencil, incrementally reduce the rates, and secure another five-year extension.

A win-win game, right? We each played the game, and we each won a little something out of it. For the buying organization, the win was a price reduction. For us, the victory was another five years of revenue to push products through our assets. Of course, we didn’t like reducing the rates. But as long as we were making solid profits, we would rather slightly reduce our margin than risk losing the business to another provider.

The game worked well for many years. Somehow, we always found ways to offset our margin erosion in other areas. After all, we were the incumbent. We knew the business. And, of course, we knew how to play the game well after the contract was inked each cycle.

One of the most common countermoves 3PLs make in the buy-sell game happens when the customer has special requests. We prided ourselves on our flexibility and excellent customer service, and would jump through proverbial hoops to deliver. Of course, we also gladly billed the buying organization for hoop-jumping, which, of course, helped us recoup the profits we had lost during the bid cycle.

This worked out well for many years. That is, until the proverbial “new sheriff rode into town” when a new manager at the buying organization took over the relationship.

Instead of the buying organization going through the motions of putting the work out to bid and accepting our protectionist rate reduction, the new manager accepted a bid from one of our competitors that involved a significant cost decrease. Simply put, we lost the business. We naively thought we had much stronger relationships than actually existed.

In addition, the winning provider promised innovation and year-over-year improvements. What the new provider didn’t know was that after the business was awarded, the contracting process was more or less the same. The buying organization would say all the right partnership words only to follow them up with an old-school cost- and penalty-driven contract and relationship. Without significant changes in old habits, the value promised would soon be erased, and our competitor would be blamed. And they would be sitting on a five-year contract with razor-thin margins, if profitable at all—Gresham’s Law in practice.

Of course, we should not have been surprised. We knew this tactic well; we had used it against our competitors to unseat them—especially on large contracts that could drive significant top-line revenue. We, too, would promise innovation with the hope (and almost certainty) that we could “nickel and dime” the buying organization with hoop-jumping after the contract was signed.

SOLUTION: BE VESTED IN EACH OTHER’S SUCCESS

Can the 3PL industry escape being caught up in Gresham’s Law? Yes, overwhelming research shows that those that can change the game from merely saying “strategic partners” to becoming true strategic partners deliver higher levels of service, reduced costs, and competitive advantage while also delivering higher margins for the 3PL. A true win-win situation versus the false one the industry has come to believe. Creating such a relationship, however, requires changing the contracting process from one that focuses on transactions to one that focuses on relationships.

Consider the following insights from two Nobel Prize-winning economists.

Oliver Williamson (2009 Nobel Laureate)—known for his pioneering research on transaction cost economics—observed that all complex contracts with detailed statements of work will ultimately prove to be incomplete. That’s because business is dynamic, while most contracts are static. When business plans change (or a pandemic hits), a too-rigid contract limits innovative responses and creates friction (transaction costs). Williamson, instead, promotes the idea of developing more flexible contracts that incorporate mechanisms for governing the relationship between the two parties to promote collaboration and continually align the companies’ interests.

Similarly, Oliver Hart (2016 Nobel Laureate) believes that companies need to move away from an adversarial approach to contracts. In the Harvard Business Review article “A New Approach to Contracts: How to Build Better Long-Term Strategic Partnerships,” Hart, along with David Frydlinger and Kate Vitasek, outlines a new approach for “a formal relational contract.” Hart and his coauthors define a formal relational contract as a legally enforceable written contract establishing a commercial partnership within a flexible contractual framework that is based on social norms and jointly defined objectives. These relational contracts prioritize the continuous alignment of the parties’ interests before the commercial transactions.

This concept of a formal relational contract aligns with the work that Vitasek and other University of Tennessee researchers have spent almost a decade doing to create a methodology called Vested outsourcing. Vested outsourcing aligns a buyer’s and a supplier’s interests through a formal relational contract based on mutually defined business outcomes. Using an outcome-based economic model means the parties have a vested interest in each other’s success; a win for the buyer is a win for the supplier, and vice-versa. The parties focus on outlining “what” the outsourced relationship should accomplish instead of “how” the work should be done. We believe that a Vested approach is a particularly good fit for 3PL contracts because they involve complex, long-term relationships where it is difficult to predict every scenario the provider might face. (For more about Vested outsourcing, see the sidebar.)

Intel/DHL and Dell/Genco (now part of the FedEx family of businesses) were the first two pairs of companies to pilot the Vested methodology for creating formal relational contracts. In both cases, the companies chose to pilot Vested because they felt “stuck” with their existing relationships and felt a competitive path would be more costly and painful than looking inward to drive changes. The companies adopted a relational contract that specified desired outcomes instead of providing detailed statements of work. The contract also defined how the relationship between the client and 3PL would be managed at the executive, management, and operational levels. The results were nothing short of sensational, with the companies reporting a significant cost structure reduction (up to 50%), record improvements in service and quality, and higher profits for the service providers. Since those early days, 57 companies have piloted Vested for one or more outsourcing deals.

But if companies like Intel/DHL and Dell/FedEx are having success with Vested, why hasn’t it more fully taken off in the 3PL industry? Our belief? The 3PL industry has been too ingrained in the status quo and reluctant to change.

THE TIME IS NOW

However, it is now well beyond time for the 3PL industry to reset if it wants to avoid being pulled deeper into the Gresham’s Law vortex. The business environment has changed too much in recent months, and the industry needs to evolve and innovate in order to keep up.

A Department of Homeland Security report shows that the Covid-19 pandemic has disrupted supply chains worldwide and revealed vulnerabilities on a scale never before experienced. From shortages of personal protective equipment (PPE) to delays in obtaining parts and materials, the report exposes the fragility of global supply chains. In addition to this physical stress on today’s supply chain, a Texas A&M study estimates that buying organizations and their providers are experiencing significant commercial stress. The predictions are stark: U.S. gross domestic product (GDP) over the next year is expected to fall by 11.9% ($2.5 trillion) and employment by 12.2% (19 million full-time jobs). There’s no doubt that buying organizations and their 3PLs will be back at the negotiating table as they scramble to adjust.

In times of crisis, having a trusting and collaborative relationship will improve the odds of eliminating supply chain disruption. But what happens to those that do not develop genuine win-win relationships? Oliver Hart calls it “shading.” Shading is a retaliatory behavior in which one party stops cooperating, ceases to be proactive, or makes countermoves. Shading happens when a party isn’t getting the outcome it expected from the deal and feels the other party is to blame or has not acted reasonably to mitigate the losses. The aggrieved party often cuts back on performance in subtle ways, sometimes even unconsciously, to compensate.

Shading happens because contracts—like it or not—create what Hart calls “reference points.” For example, the contract sets an expectation on a price for the buying organization and an expectation on profit for the 3PL. When unanticipated events occur and the parties need to evolve, the contract all too often anchors the parties in past expectations and the status quo.

Consider a contract where the buying organization is overly prescriptive with its statement of work. In essence, it has created a situation where the provider is contractually obligated to deliver the status quo, even if the status quo no longer exists. Or consider when the contract lays out transactional pricing where the provider gets paid for every pallet. Why work on ways to improve throughput and efficiency if it will lead to fewer pallets stored and lower revenue? And what will happen when providers push back on price reductions because they are not as profitable (and most likely are losing money) due to lost volumes and/or increased costs in the wake of Covid-19?

The stark reality is the Covid-19 pandemic will likely pit buying organizations and their 3PLs against each other and will be ripe for shading, as it is likely that one (or both) of the parties involved in a contract will find its expectations are not being met.

It makes sense when you think about it. Supply chains require certain interdependencies—both internally and with providers. In our experience, companies with little to no collaboration among internal departments and external providers had the most issues with day-to-day disruptions during normal times. These companies were the weakest going into the pandemic and most certainly will face the most challenges coming out of it. Companies that have strong collaboration among internal departments but lack collaboration and strong relationships with providers do a little better but are far from optimized.

The real winners are organizations that have created supply chains where all parties—including providers—are vested in each other’s success. The Vested methodology does this by creating a flexible contractual framework based on jointly defined objectives. Contracting parties prioritize their relationship and the need for fair and balanced continuous alignment of interests before the commercial transactions. In practice, how does this work? They create a relational contract based on proven social norms and governance mechanisms that aid the parties in effectively managing through the dynamic nature of business.

In short, the parties win (and lose) together. These organizations have the highest level of resilience because they are not pitted against each other in the classic game of buying and selling; rather, they are spending their time and resources on solving tough supply chain problems. And, while not perfect, these collaborative companies almost certainly reacted much better to pandemic-related challenges and will be best positioned to come out ahead in the future.

IMAGINE THE NEXT GENERATION

Imagine what would happen if companies stopped simply saying they were “strategic partners” and truly started acting as strategic partners? What if buying organizations abandoned their age-old commodity-based procurement practices, and 3PLs also quit playing the buy-sell game? What if, as opposed to buying organizations requesting providers to “just do this,” buying organizations and 3PLs together set out to create formal relational contracts? In doing so, they would shift from traditional, transactional contracts laden with inherent perverse incentives to a formal relational contract that establishes a playbook for how to work together collaboratively to address supply chain disruptions.

We have been imagining this for years. In fact, we have been espousing it for almost a decade at conferences and industry events. People nod their heads, but rarely does one see change.

But, as the saying goes, there is nothing like a good crisis to drive change. We argue that the time for change is now—or the 3PL industry risks falling further victim to Gresham’s Law in the wake of the Covid-19 pandemic that has disrupted our supply chains like no other event in recent history.