Volume commitments as part of contract negotiations

When you signed that contract, you were absolutely sure that you could guarantee that spend and the volume commitment felt like a piece of cake… now though the world has changed and that contractual obligation is going to potentially cause irrevocable damage. What can you do?

What is a volume commitment? 

Very simply, a supplier will offer a more competitive price in return for increased revenue and will therefore provide a lower unit, or service consumption price for a higher unit/consumption commitment. The lower price offered is therefore explicitly linked to the client’s ability to commit to that level of spend.

These commitments are often formalised within a contract, a letter of understanding (LOU) or other form of purchase order agreement and may be fixed or variable throughout the term. The key is, the supplier expects the buyer to meet the commitment, in order to benefit from the lower pricing.

What are the benefits of volume commitments?

The benefit to the buyer seems obvious – they can obtain a more competitive price. However, the reality is that the benefits are felt more on the supplier side.

In the first instance, it can put them at a competitive advantage. They are seen to be flexible on pricing from the outset, positioning them ahead of their competitors. It also tends to lead to a higher level of client retention – clients understand that as long as they meet the volume commitments – they will receive continued discounts. It’s a win-win and the the supplier is more likely to secure ongoing revenue.

Historically these agreements were put in place for two key reasons:

Historically these agreements were put in place for two key reasons:

1. Because there is a higher up-front risk for the supplier. Perhaps they have to acquire equipment or other assets on behalf of the client in order to be able to provide the outsourced service. In this case the volume commitment ensures that the supplier recoups the additional upfront cost throughout the term of the contract.
2. The contract is drafted at speed. Often there is an urgent need for a particular service (think IT infrastructure for example). In this case, suppliers are sometimes asked to finalise contract negotiations without the time for thorough due diligence. By requiring the client to commit to a certain level of business, they are – to some extent – providing a level of cover for any unforeseen costs in delivering the service.

These commitments can therefore be a good way to obtain greater value and from a competitive standpoint, there is nothing wrong with the methodology – the more a buyer spends, the better the discount they receive.

However, the snag comes when the volumes decrease, particularly if the decrease is totally unexpected due to unforeseen circumstances such as Brexit and Covid. The less a buyer spends, the discount reduces and in the worst case, the buyer is in breach of the agreement by not meeting the minimum volume commitment required. 

Understanding the issue with volume commitments

In order to calculate volume commitments during a contract negotiation, the supplier will look at a baseline spend over a recent 12-48 month period. The supplier will then establish a % by which the buyer must increase their spend year-on-year.

Let’s look at a specific scenario to better understand the issue: Let’s say the buyer has committed to an annual volume of 20,000 units/hours and for anything over this, in increments of 5,000, the supplier provides a further unit/hourly cost reduction of 3%.

Normally this was a safe bet, annual volumes were more in the region of 40,000 and therefore the unit/hourly price was low and there was no danger of breaching the agreement by missing the minimum commitment (20,000).

Now demand has reduced and therefore the buyer is struggling to order the minimum volume but contractually, is obliged to do so – otherwise it could be terminated, or baseline prices increased.

Further, for those units still being purchased, the buyer is having to pay a higher unit/hourly price than they are used to, and this means their margin is being negatively affected.

The impact is felt across the organisation but also across the entire supply-chain; the buyer’s reduction in spend means a supplier’s reduction in revenue and margin. Everyone suffers creating a lose-lose scenario.

Resetting the baseline: How to strike the right balance when Negotiating Contracts

Now, more than ever, a contract negotiation should be entered into as a two-way street, and a natural win-win arrangement found. Any misalignment or misunderstanding could be damaging, or even terminal for all parties involved.

It’s critical to re-set the baseline and consider what volume can be truly met and what price increase you can accept to retain and protect your supply chain.

Now is not necessarily the time to be thinking about doing things differently or managing a complex tender for a new provider. Looking after your incumbent supplier and attempting to come to a mutually agreeable arrangement will ensure supply chain stability.

During negotiations, it is important to prepare and acknowledge that everyone will push for the maximum they believe they can get. It’s up to you as the buyer to control this urge and ensure that something amicable and realistic is agreed by following the key five steps.

If you consider the primary negotiation steps and associated negotiation styles that you can adopt, you should absolutely be aiming to achieve collaboration. This may mean giving up some of the discount in return for a lower volume commitment, or perhaps extending the term of the agreement to still provide the required revenue over a longer-term. The key here is recognising what best fits both your organisation and the supplier to reach a win-win.

Put another way, relationships simply do not work when either party over leverages negotiation, they may function for a while but issues will creep in overtime, or even worse the relationship can become toxic.

Strong supplier relationships are key – especially now – and it’s better to foster a long-term supplier partnership where both parties can support and protect one-another during this economic uncertainty.

If you’d like advice as to how to handle negotiations, visit our Contract Renegotiation service page.