Contracts that focus on lowest price can harm profitability.

“Point 4 – End the practice of awarding business on the basis of price tag alone. Instead, minimize total cost by working with a single supplier.” – W. E. Deming

Quality can be defined as “fitness for use.” As members of a supply chain, manufacturers and service providers use materials from suppliers to create products for their users. Each party must receive a product that is fit for use so that it can be processed and meet the next user’s needs. This month’s column focuses on the legal relationship between producers and their external suppliers.

When production is understood as a process, it seems obvious that members of the supply chain should communicate to understand each other’s needs. Within an organization, management can implement policies that facilitate interaction among departments and personnel. The relationship between a producer and an external supplier is governed by contract law.

Contract negotiation can be adversarial or collaborative. Adversarial parties take self-serving positions. They might focus on extracting maximum price concessions. A shortsighted focus on purchase price ignores the total cost of production. A party who simply chooses the lowest priced supplier may ignore costly alterations further down the supply chain. A different grade of supplies may require modifications and result in critical quality changes that increase the costs of poor quality, such as warranty costs. Thus, focusing on obtaining the lowest price alone can reduce quality, erode profits and destroy goodwill.

Collaborative parties think of each other as partners pursuing a mutual goal or solving a common problem. Internal customers, purchasing personnel and suppliers communicate. They view production and improvement as continuous processes, not a series of unrelated transactions. While each input may not have been obtained at the absolute lowest price, a strong relationship with a dependable supplier that values efficiency, loyalty and cost reduction can provide greater certainty and higher quality.

Not all managers, personnel and legal counsel will subscribe to this cooperative approach. Over time, however, producers with a cooperative mindset will likely discover that most production inputs come from a “vital few” suppliers with whom they can establish their most productive relationships.

The nature of the producer-supplier relationship will influence their contract. At the outset of their relationship, even the most honorable parties must develop trust and evaluate the prospects for their long-term compatibility. Early on, the parties will likely have a more formal, less collaborative relationship. As trust grows, the parties will likely streamline the contract negotiations and simplify the legal documentation.

Written contracts and related documentation are business tools that can facilitate a business relationship. A producer and supplier can use a contract to:

establish teams to discuss their needs.

specify performance metrics and means for collecting and measuring data.

agree on minimum performance standards relating to defects and delivery.

specify the process for taking corrective action.

To choose and maintain relationships with suppliers, producers must evaluate suppliers’ performance including their quality system, business health and product quality.

Before contracting, parties usually conduct due diligence. A producer may audit a supplier’s plant to certify the quality system. A contract may identify the certification standard-for example, ISO 9000-that the supplier must maintain. Producers with sufficient leverage may require that the supplier adhere to certain covenants or contractual promises to ensure that they maintain their financial health (for example, a limited level of debt), production capacity and technological expertise.

A long, formal contract filled with incentives for good performance and penalties for bad performance won’t help an honest party if the counterparty is untrustworthy. If you sense that the other party is dishonest, undependable or argumentative, find a more amicable business partner. By avoiding or ending bad relationships, you can focus on productive ones. Keep searching until you find them.

Disclaimer: This column is for informational purposes and does not constitute legal advice.