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Buyers generally acquire a mix of long- and short-term contracts, with the goal of finding the optimal trade-off between price and flexibility.
For both buyers and sellers, forward contracts guarantee the exchange of a known quantity of goods at a known price and for a given time frame. From the buyer's perspective, such a contract not only guarantees delivery of a critical good, at an agreed upon price, but also reduces the costs of procurement operations, as prices do not have to be negotiated continually.
The contract lengths selected generally depend on the lifecycle of the industry and product. For example, in the pork industry, the type of product and product specifications (quality, delivery points, lot sizes, etc.) could be considered constant, and demand easily forecasted. As a result, hog cash contracts typically have durations of 3 to 7 years. 1
Companies such as Intel, with products such as CPU processors that have shorter lifecycles and less predictable demand, negotiate contracts anywhere from every quarter to every several years. Multi-year contracts typically are avoided. 2
Electricity, as a commodity, has fairly constant quality and definition, and total market demand can be forecasted reasonably well. 3 In other words, electricity can be viewed as a commodity with a long product lifecycle, and contract durations of 3 to 10 years seem reasonable.
Long-Term Cooperative Supplier Relationships
One recent trend in industrial purchasing is a decrease in the number of suppliers and an increase in longer-term contracts and cooperative supplier relationships-bolstering the view that buyers benefit by buying for the long term. This trend provides useful insights for default electric service provision.
Honda, Wal-Mart, Harley-Davidson, Toyota, and American Airlines have found that suppliers can contribute creatively to cost reductions, product development, logistics operations, and an improved bottom line. These major firms also have begun to acknowledge that suppliers must achieve profit margins sufficient for them to invest in new technologies, facilities, equipment, and people. To achieve this, both parties are making their cost structures and margins more transparent.
Chrysler Corp. is one of the greatest success stories in restructuring processes and relational contracts with suppliers of key commodities. Traditionally, Chrysler designed products largely without input from suppliers. The company chose suppliers solely on the basis of price through a competitive bidding process. Chrysler dictated the terms of all contracts and limited their duration to two years.
In a major turnaround, Chrysler implemented a program to reduce its costs without hurting supplier profits. Chrysler now deeply involves suppliers in its processes and strives to find ways to lower costs together. Suppliers are now involved in the development stage of vehicles a full 180 weeks prior to volume production, rather than the previous 75 to 100 weeks. Contract times more than doubled to 4.4 years on average. Suppliers are expected to offer suggestions that result in cost reductions equaling 5 percent of the supplier's sales to Chrysler. In return, Chrysler not only gives suppliers 90 percent of the business for the life of each car model through oral agreements, but also a percentage of all implemented savings.