I interviewed Greg Boring who discussed Outsourced Logistics and Collaborative, Outcome-Based Pricing Structures.
Please provide a brief background of yourself?
My background is in engineering and operations. I received a bachelor’s degree in Industrial Engineering from the University of Pittsburgh and followed that up by earning an MBA with a finance concentration from GA State University. I began my career in transportation, working for Yellow Freight System in their management trainee program before progressing into their Industrial Engineering department. I then moved into the Logistics world working for GA Pacific Corporation and UPS-SCS prior to joining Kenco. Most of my career I’ve worked in positions related to engineering, operations, pricing, or solutions design. I first moved into a sales role when joining Kenco. I have been here about 8.5 years. Half of that time was spent in operations managing the network Kenco operates for one of our largest customers, and the other half of that time has been in sales.
Kenco is the largest, privately held 3PL in N. America. We are a vertically integrated logistics provider – meaning that we are a one-stop shop for N. American Logistics. The services we offer include value added distribution and fulfillment, comprehensive transportation management, material handling equipment solutions, real estate management, and systems solutions.
What are collaborative, outcome-based pricing structures?
In the logistics world, as well as in many other industries, many sourcing relationships are very transaction based. The customer is primarily concerned with reducing labor cost. The vendor/client relationships are very tactical and treat logistics as a commodity. Often times in these types of relationships the customers end up micro managing the 3PL. So, the customer chooses to outsource because they recognize that their expertise is in manufacturing and marketing their product and not in the distribution of it, but then they tell the 3PL, who is an expert in distribution, how they want it done, which creates a strange, often tense relationship. These types of relationships typically involve a cost-plus management fee structure where the 3PL passes through all costs to the customer and adds a small management fee markup.
Then, ironically, the customer sometimes criticizes the 3PL for not being innovative and doing a better job of reducing cost. Well, if you think about it, the cost-plus management fee structure is a disincentive to reduce cost, because when costs are reduced, so is the supplier’s margin. Secondly, when customers issue this challenge, they often don’t recognize that there is a cost for innovation – it is rarely free. The service provider’s onsite management staff is usually very good at managing processes, training employees and holding them accountable. But often times the type of innovation customers ask for involve larger changes, such as improving facility layout, enhancing product storage and conveyance equipment, implementing improved systems, or implementing network-wide process changes. This type of innovation involves outside support such as engineering resources. Many 3PLs have these resources but they come with a cost. In a traditional cost-plus relationship, when a customer challenges a provider to be innovative, often what they have in mind is for the 3PL to reduce the customers cost without considering the expense the 3PL will have to go through to do that. It puts the 3PL in between a rock and a hard-place. In a collaborative, outcome-based pricing structure the focus is on the “what” and not the “how”.
What this means is the customer and service provider come together and agree on a small number of key metrics that will be used to measure success. Logistics expense as a percent of revenue is a good example of one of these key metrics. Then it is up to the service provider to use their expertise to figure out how to hit those targets. And if they do there is the opportunity to increase, possibly significantly, the management fee they will earn. This gives the service provider the incentive to invest in the relationship and look for ways to be innovative and reduce costs, because there is a clear path for how they can get a positive return on their investment. Likewise, the service provider takes on some risk by putting a portion of their management feet at risk by not hitting the mutually agreed upon targets.
So, as an example, under the same cost-plus management fee structure I just described, let’s say the customer and service provider agree to a 10% management fee as a target. If the service provider does not deliver on the mutually agreed upon goals, they could put up to 50% of their management fee at risk and only earn a 5% management fee for the given period. This is their “skin in the game” or the amount of risk they take. Likewise, if the service provider significantly exceeds the mutually agreed upon goals, they could earn up to 30% management fee. These are the guidelines offered by Kate Vitasek who developed the Vested Outsourcing model that is becoming increasingly popular. Now 30% may seem like an excessive management fee, but if you think about it, if structured properly the customer benefits just as much, if not more, than the service provider when this type of performance is delivered. Think of the cost benefit the customer received in return for the service provider’s performance that earned them that type of incentive.
What are the benefits?
If handled correctly, it creates a strategic partnership instead of a tactical, arms-length, us vs. them vendor/client relationship. In a collaborative relationship the customer recognizes that the service provider has to earn a profit to stay in business and gives the service provider an opportunity to significantly increase their profit by meeting or exceeding the goals that are most important to the customer. Both the customer and service provider are invested in the other’s success. By helping the customer be more successful, the service provider also enjoys success, and vice versa.
Why do you believe so strongly in this approach?
For one, even though it is a relatively new concept, I have seen it work. When business partners are invested in each other’s success, that creates a lot of positive energy in the relationship. Success breeds success. Success also leads to long-term relationships, which are by far the most profitable for both the customer and the service provider. It costs a service provider significantly more to gain a new customer than it does to retain a current customer. Likewise, the customer is exposed to both cost and risk when switching vendors. So by partnering with a company you trust and then forming a pricing structure that leads to a win-win relationship where both companies share in success, you have a solid foundation for a long-term productive relationship.
Do you have any success stories or examples?
The best example I have is a relationship with a customer who has been with us for about 8.5 years. Initially, our scope of work with this customer included managing their one U.S. based warehouse along with a dedicated transportation fleet that provides white glove delivery service to their customers across the country. We also managed the shuttling of product between the manufacturing plant and the warehouse. In 2008 we performed a network analysis which validated the benefits of implementing a hub and spoke network to serve their customers. What this means is that instead of all customers being served directly out of one central warehouse, there were significant benefits related to transportation savings and improved customer service by opening smaller, regional distribution centers closer to their customers. So over the next three years we opened and now operate 9 regional distribution centers and also manage the movement of product from the central DC to the regional DC’s and then on to the end customers.
At about the same time as the rollout of the regional DC’s was completed, our agreement with this customer was coming close to expiring. The decision at that point was to move toward a collaborative, outcome-based pricing structure. The key attributes of the pricing structure are, it is very simple. It is a cost-plus, open-book relationship. The key metric Kenco is held accountable for is logistics expense as a % of revenue. This is the key cost metric our customer’s senior leadership looks out when monitoring the performance of their supply chain. Also developed was a structure for how Kenco would share in the benefits of achieving or exceeding the agreed upon goals. The customer then stepped back, let us do what we do best, and monitored our performance without micro-managing us.
This made it easy for us to make the decision to invest resources in the relationship to ensure the logistics expense as a % of revenue goal was met or exceeded. We have two full-time business improvement managers assigned to the account at Kenco’s expense because we know that they will more than pay for themselves based on the savings and efficiency improvements they will deliver. Our management staff also received Lean Six Sigma training and we now have several Kenco greenbelts and blackbelts assigned to the account. In fact, the black belt project completed by one of our employees generated $1.6 million in savings for our customer.
There is a long list of other projects Kenco has completed, including others that have generated 7-figure annual savings or provided value in other ways. In addition, at the customer’s request, we have provided 6-sigma training to several of their employees, some of whom work in completely separate business units that Kenco currently doesn’t work with.
The results are easy to see. In the last two years, our customer’s revenue has increased 18% but their logistics expense has remained flat, which has obviously pleased their senior leadership. Now our primary contacts are selling Kenco internally to other divisions within the organization, which we hope will lead to additional growth. Perhaps the best example I can offer regarding what this has done to our relationship with this customer came out of a quarterly review we held with them just two weeks ago. At the end of the meeting, the customer told us that we have them right where they want to have their customers. They can’t imagine doing business without us. Needless to say, that was a great way to end the meeting.
About Greg Boring
Vice President of Sales at Kenco Group, Inc.