By Mykola Oleksyn and Tony Kook
Editor’s Note: The SCM thesis Better Contract = Better 3PL Performance was authored by Mykola Oleksyn and Tony Kook and supervised by Dr. Mehdi Farahani (email@example.com) and Dr. Maria Jesús Sáenz (firstname.lastname@example.org). For more information on the research, please contact the thesis supervisors.
Fast-moving consumer goods (FMCG) companies compete in a low-margin business environment. As a result, cost-efficient supply chains are critical for driving profitability and maintaining a competitive edge.
FMCG companies usually outsource their supply chain management to third-party logistics providers (3PL) and spend a whopping 7.5% of revenues on such services. Unsurprisingly, FMCG companies put pressure on 3PLs to lower their costs.
The compensation package and the relationship between a 3PL and an FMCG company are typically governed by a performance-based contract. Well-designed contracts promote a value-driven relationship between the buyer and the supplier. However, poorly designed contracts may create misaligned incentives and lead to subpar 3PL performance.
For our capstone project, while working with a global FMCG company, we studied the financial impact of switching from a performance-based contract, pain/gain share (PGS), to a value sharing contract (VSC). The PGS model shares the cost savings and budget overruns with the 3PL, while the VSC model shares the risk and reward based on the supplier’s operational efficiencies and cost savings.
Under the new model (VSC), two-thirds of the total 3PL compensation depends on cost-related key performance indicators (KPIs). By contrast, under the previous contracts (such as PGS), only about one-third of overall compensation depended on cost KPIs.
Can’t always get what you want
The VSC model is built on the idea that increasing the degree of risk/reward sharing and creating stronger incentives for achieving cost performance goals will improve the efficiencies of supplier operations. Our FMCG sponsor company wanted better cost performance, so it started paying more for cost savings and performance improvements. The idea sounds simple and quite logical. But did it work? Did the FMCG get what it wanted?
We used the difference-in-differences (DID) model to compare the changes over time between the cost performance (cost per pallet) in the periods before and after the contract changed. We used the least absolute shrinkage and selection operator (LASSO) method and insights from stakeholder interviews to determine the variables that best explain the variance in cost performance of the 3PL. The variables used were pallet volume, labor costs and forecast errors.
After validating the required assumptions and conducting robustness checks on the DID model results, we found no causal link between the new contract and the changes in the cost-per-pallet performance of the 3PL. The findings suggest that offering extremely high rewards for the outcome you want (in this case, lower costs) might not always get to the desired outcome.
We synthesized our insights from a literature review, our stakeholder interviews, and our quantitative analysis to create a framework that will help managers better understand and improve existing 3PL contracts. Our framework presents the key elements and trade-offs of a value-driven 3PL service contract.
Get what you need
Our 3PL service contract framework proposes that achieving the contract’s goal relies on mutually consistent execution of the three key components: performance measures, compensation structure, and governance processes. In addition, we describe the key features that define each primary component. We may also think of such features as levers that define key trade-offs inherent in the contract (“pushing” one lever impacts other levers).
• Performance measures define what gets measured.
Features: KPI selection, goal-setting processes, and evaluation processes
• The compensation structure is built on performance measures and aligns the metrics with incentives.
Features: base-level compensation, risk/value sharing plan, KPI compensation weight setting
• The governance process is responsible for turning the contract from just a document into the essential cornerstone of a business relationship.
Features: managing control mechanisms, data governance, and contract complexity.
We suggest that 3PL service contract management requires a balanced approach. Choosing a favorite metric might force managers to play Whac-A-Mole, fighting unintended consequences. Instead, managers can benefit from our three-part framework to learn how key components and levers of contract design and execution are interrelated.
Every year, approximately 80 students in the MIT Center for Transportation & Logistics’s (MIT CTL) Master of Supply Chain Management (SCM) program complete approximately 45 one-year research projects.
These students are early-career business professionals from multiple countries, with two to 10 years of experience in the industry. Most of the research projects are chosen, sponsored by, and carried out in collaboration with multinational corporations. Joint teams that include MIT SCM students and MIT CTL faculty work on real-world problems. In this series, they summarize a selection of the latest SCM research.