Do Supplier Penalties in contracts work?

March 27th, 2012

We have noticed an increase in discussions related to the effectiveness and benefits of including supplier penalties in contracts.

We have noticed an increase in discussions related to the effectiveness and benefits of including supplier penalties in contracts. From the recent opinions expressed, it appears that in the world of IT and Telecom, penalties included in Service Level Agreements (SLAs) are viewed as necessary and acceptable and are usually accompanied by financial incentive awards for exceeding SLA requirements. Other opinions note that penalties in product agreements can be counterproductive. The goal of penalties is usually to improve supplier performance and responsiveness.

Some large retailers such as Wal-Mart include penalties in the normal course of business as a standard operating practice. Wal-Mart made news in February of 2010 when they announced they would begin charging a 3% cost of goods penalty to suppliers and carriers that failed to deliver goods within a 4-day “must arrive by date” window.

Other companies, such as PEPBOYS, clearly list its vendor requirements on their website and include penalties such as 5% of the cost of items not shipped if the on-time fill rate falls below 95%.

What constitutes an effective penalty will vary from one contract to another. Penalties should be clearly defined for the supplier. When determining penalty amounts, ensure that the penalty has enough “bite” that it will cause elevated visibility within the supplier’s organization. Remember, if penalties are too numerous or frequent, they can become a burden to manage and consume your staff resources.

So, what’s the downside? Vendor penalties and fines can increase your cost of goods sold over time. Just the threat of penalties could be enough to cause a supplier to not want to do business with you. In the end, the use of penalties should always be legitimate and not a means of making money for your organization.

If you are looking to achieve the lowest cost of goods sold, contact SafeSourcing to see how we can help.

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