Dr. David Hillson's article “Exploding a common myth about risk management,” that appeared in our March/April edition,1 sparked a robust response from transportation and logistics industry expert, commentator and author, Phil Coughlin – and a new white paper titled Unpacking Risk Shifting: Challenging Unreasonable Risk-Shifting in the Transportation Logistics Industry. 2 The white paper is a call to action for GSCs and 3PLs to drive proactive and positive changes in the transportation and logistics industry to create fair and balanced commercial agreements that promote healthy businesses on both sides.
On reading Dr. Hillson's article Phil Coughlin had this to say, “It was a thought-provoking article - the following point jumped off the page: Unfortunately the prevailing negative view of risk spawns a combative approach to contracting, because owning risk is always seen as a 'bad thing'. Here's what often happens. The buyer passes as much risk as possible to the seller, always at the minimum price of course, while the seller is naturally defensive and reluctant to accept risk, and responds by loading the price with a risk premium.
Risk is loaded onto service providers
In particular, I point to the words underlined above. This “loading” does not happen in the logistics industry. Procurement professionals have calculated correctly that they can separate risk from price, thus they treat the buying of transportation services as a commodity – like buying basic office supplies. Yet, at the same time through the contracting process they shift lopsided amounts of “inherent risk and cost” in their supply chain over to their 3PLs.
There are a few key reasons why this happening:
- GSCs are under extreme price-per-unit pressure from their own customers, so have turned their attention to their supply chain in an effort to drive down transactional cost and shift inherent risk in their business model.
- The GSCs have learned that 3PLs will recklessly pursue more freight.
- Once the procuring is finished, procurement moves on to the next category or purchasing initiative. The true cost of this methodology is felt across a disparate network of entities in dribs and drabs - the true impact of which will only be apparent if and when someone adds it all up.
- The result is generally not a single nor a series of big service failures, but rather the slow drip of service degradation across a global network and the withholding of innovation.
Are 3PLs aware of these onerous and lopsided contracts?
Too many 3PLs are either not fully aware of these contracts (signed below the corporate radar) or do not fully appreciate the risk exposure tucked into them. They either adopt a “cross that bridge when they come to it” approach, believe in the myth that they can fully insure their exposure, or simply have no intention of honoring those contract terms (one of reasons we now see GSCs requesting a right of offset). Is the logistics industry the canary in the coal mine when it comes to current procurement and contracting practices? Procure as if you are buying a commodity, i.e. the service provider is of no strategic value, and the buyer has options:
- Orchestrate an RFI / RFQ process with service requirements that call out for “strategic partnership,” high value-added services and innovation.
- Bridge this gap between paying for a commodity, yet requiring a strategic partner, by imposing an onerous and lopsided service contract.
“Heads I win – tails you lose”
Most GSC service agreements that I come across are loaded with onerous terms and conditions. The following are a few of the many examples the “standard” demands being made in GSC's service agreements:
- Liability - It is commonplace for a GSC to demand full value replacement liability for cargo loss or damage while expressly invalidating international industry standards such as the Warsaw Convention3 or the Montreal Protocol.4 I liken this to a commercial passenger airline losing their luggage and informing the airline that their Rolex was in it. The airline will not and cannot pay for the lost Rolex. The airline must know their liability limits (costs) if they are going to offer a $200 fare from Boston to Chicago. In the logistics-transportation sector the GSCs are commoditizing the rates, while simultaneously requiring excessive liability limits, i.e. free “all risk” marine cargo insurance. It is a myth that you can “load” the cost of full value replacement liability into a commoditized quote. You're likely to wind up with a version of Russian roulette, with the GSC and the 3PL hoping a major cargo loss or damage incident does not occur. It is reasonable for a GSC to require a 3PL to take a calculated risk, but that risk should be calculable.
- Codes of conduct - Almost every GSC service agreement requires the 3PL to agree to comply with the GSC's code of conduct. On the surface this seems like a reasonable and straightforward request. After all, a code of conduct addresses ethical, social and moral standards, so why not? The challenge occurs when the 3PL has its own substantive code of conduct. Logically, a GSC retains the unilateral right to add, modify and delete its code of conduct to fit its mission, vision and cultural attributes. One GSC's code of conduct may share common themes with another GSC, but each GSC's code will be different. How is a 3PL required to adopt each GSC's code of conduct to comply with this request? How does a 3PL comply with 10, 20, or 30 different codes of conduct? More importantly, what does this willingness to say “yes” to everything mean for the 3PL's own code of conduct? A company that says “yes” to everything is likely to stand for little. Most GSC service agreements consider violation of their code of conduct a breach of contract, thus subject to penalties, indemnification exposure, or termination for cause. Can a 3PL consume, implement and comply with 10, 20 or 30 different codes of conduct throughout their company and subcontractor network? No they cannot: so the GSC and 3PL implicitly enter into a “nudge-nudge wink-wink" arrangement of “just sign that you will comply, so we can check that box.”
It is reasonable for GSCs to require their 3PLs to have “skin in the game,” (i.e. incurred monetary risk in achieving the goal). 3PL's should be held accountable for their performance. However, it is important to note that in almost every GSC service agreement a section exists that expressly states that the GSC is under no contractual obligation to provide any business to the 3PL. Where is the mutual beneficial commitment?
Our white paper outlines the issues now facing the logistics industry and expands on my observations with some graphic examples. The white paper was inspired by a discussion between Phil Coughlin and Kate Vitasek, faculty member, the University of Tennessee's Haslam College of Business Administration, about poor contracting practices in the logistics and transportation sector. The discussion expanded, and the concept of a white paper was born. Passionate industry leaders joined in the discussion, becoming authors and contributors. All felt strongly that the entire industry—buyers and suppliers—will benefit from this paper.
Taking advantage of risk naivety?
Pleased with the interest his original article has generated, author Dr. David Hillson, agreed that risk balance can often be asymmetric, resulting in one party carrying more risk than they realize, or can bear. He commented, “This often arises from a difference in risk maturity between the contracting parties, allowing one to take advantage of the other's risk naivety. Tackling this requires education, and this article is a small step towards this goal.”
- Dr. David Hillson's original article “Exploding a common myth about risk management” appeared in the March/April edition of Contracting Excellence.
- “Unpacking Risk Shifting: A White Paper Challenging Unreasonable Risk-Shifting in the Transportation and Logistics Industry,” by Kate Vitasek, Phil Coughlin, Peter Moore, Adrian Gonzalez, Karl Manrodt, Emmanuel Cambresy and Andrew Downard (University of TN http://www.vestedway.com/vested-library/) Sign in required for reading access, but free of charge.
- The Convention for the Unification of certain rules relating to international carriage by air, commonly known as the Warsaw Convention, is an international convention which regulates liability for international carriage of persons, luggage, or goods performed by aircraft for reward https://en.wikipedia.org/wiki/Warsaw_Convention.
- The Montreal Protocol is an international treaty designed to protect the ozone layer by phasing out the production of numerous substances that are responsible for ozone depletion. https://en.wikipedia.org/wiki/Montreal_Protocol
ABOUT THE AUTHOR
Philip Coughlin has worked for Expeditors International of Washington Inc. for 29 years, and is currently the President of Global Geography and Operations.