PSL REMUNERATION FORMS – FROM PRICE SCHEDULES TO GAIN SHARING

Relationships between logistics service providers (LSPs) and shippers have changed. They are becoming more complex, with service providers becoming more deeply involved in the operation and taking greater responsibility for their performance.

The forms of remuneration of these service providers have also changed, but currently they coexist from simpler forms based on unit rates based on price tables, to more complex forms, suitable for customized operations, where the costs and profit margins of the providers of service are determined according to their ability to increase the efficiency of the operation.

What is the best form of remuneration? To answer this question, the various existing models, their advantages and disadvantages will be discussed.

USUAL FORMS OF REMUNERATION

With regard to the usual forms of remuneration, three modalities can be chosen: based on unit fees, based on the cost of the operation plus a margin, and based on the cost of the operation plus a fixed management fee (Figure 1). Next, the differences between each of them, their advantages and disadvantages will be discussed.

The simplest and most widely used form has been that of unit rates. In this modality, the service provider can charge per hour worked, per ton moved, in short, for any unit measure of the service. Its strength is simplicity.

Although the logic of unit rate compensation is simple, some difficulties can arise. Unit rates are ultimately the result of dividing the total costs of an operation by a certain expected volume. According to our examples above, it could be total hours to be worked or total tons to be moved.

This calculation is based on a certain level of efficiency of the operation: to move x tons it will be necessary to incur certain costs (assets, labor, etc.). Problems happen when the volume of the operation is lower than expected. The real cost tends to be higher than expected, thus harming the service provider's margins, without there being a natural correction mechanism.

Another disadvantage of unit rates stems from the fact that they do not automatically reflect the operation's efficiency gains. If significant changes occur that allow the service provider to reduce its costs, it will have all the benefit for itself, unless the unit rates are renegotiated. This can become an exhausting process if these changes are not formally defined in a contract or prior agreement.

Figure 1 - Strengths and weaknesses of the usual forms of remuneration

Source: Lynch, Clifford, Logistics Outsourcing, a Mangement Guide

As an alternative to the unit rate, the cost plus margin modality solves some of its main problems. In this modality, the shipper remunerates the service provider in order to cover all its costs with the provision of the service, adding a margin, calculated on the costs of the operation.

Some variations may occur with respect to the reimbursement of costs: these may be based on a periodically revised budget, or on costs actually incurred in a given period.

For the service provider, there are great advantages in this form of remuneration. There is a guarantee that your costs will be covered and that there will be a margin at the end of your effort. Of course, in the case of budget-based costs, if there is an increase in the value of inputs needed to provide services and if there is no timely revision of the budget, the situation becomes complicated.

The advantage for the shipper is greater clarity about the service provider's margins and operating costs. Any change in the system that results in an increase in efficiency has a direct impact on the reduction of the total costs of the operation and, therefore, on the remuneration of the service provider.

The reverse situation is also common. If the shipper does not have cost references, benchmarks, there may be suspicion that the costs incurred in the operation add to the service provider's inefficiencies. Even working in an “open spreadsheet” type system, at the extreme, there may be suspicion that the service provider is increasing its costs to increase its operating margin.

It is essential, therefore, to have accurate cost references so that budget adjustments are made based on values ​​that represent efficient operating practices. Not an easy task. Some costs are more clearly determined (eg fuel consumption); others, not so much (maintenance, overhead, information systems).

There are variations on how the margin is determined. It can be defined as a rate of return on capital employed by the service provider. This is a suitable modality when there are dedicated assets. Its determination must be based on the risk of the operation: the lower the risk (for example, if there are long-term contracts with guaranteed minimum volumes), the lower the rate of return on the capital employed may be.

A disadvantage of this modality lies in the fact that the margin is proportional to the cost/assets dedicated to the operation. The higher the cost, therefore, the higher the profit for the service provider. Of course there are controls on operating costs. But there is clearly no form of direct incentive for costs to be reduced.

A variation on the modality “costs plus margin” is the “cost plus fixed management fee”. There is a clear division between operating costs and management costs. This prevents variations in the volume or prices of the operation's inputs from being passed on to management costs. This is a natural arrangement when hiring logistics service providers that do not own assets, but are responsible for managing the operation.

In this modality, although the service provider's profit is not proportional to the cost of the operation and, therefore, if the cost increases its remuneration will not increase, there are also no explicit incentives to increase efficiency.

IMPROVEMENTS TO THE USUAL FORMS OF REMUNERATION

How, then, can employment contracts objectively reflect the intention to reduce costs and improve customer service? How to generate incentives for service providers to use their expertise to improve the process? How to make the employment contract, in fact, an instrument to support the relationship and not just a legal device for legal safeguards?

The key issue seems to lie in the definition of operating agreements in which there is a direct relationship between the service provider's remuneration and profit and the quality and efficiency of its service. In the following sections, we will discuss two mechanisms that have this objective: contracts based on Service Level Agreement (SLA) and gain sharing mechanisms (gainsharing).

SERVICE LEVEL AGREEMENT

The main difference between SLA-type contracts and the usual forms of remuneration is the use of performance indicators and targets to encourage increased operational efficiency and improved service levels. This stimulus is implemented in the form of prizes, if the target is reached, or fines, if not.

SLAs define performance standards that the service provider must meet and define measurement mechanisms for comparing these standards to actual performance.

Surveys in Brazil reveal that 64% of contracts for logistics operators include some type of performance indicator and target. In the United States, this number increases to 92%.

What appears to be a simple idea is often not put into practice simply because the shipper has not taken the time to define operational indicators and performance targets suited to his business and marketing strategy. Another reason is the lack of basic measuring instruments and processes. If indicators of key company processes are often lacking, it is even more likely that indicators are lacking to regulate specific contracts.

The cost and level of service dimensions are broken down into a series of indicators, of which the most used, according to research, are listed in the table below.

Table 1 – Indicators most used in contracts between logistics operators and shippers

The development of performance indicators is a more complex task than one imagines at first glance. The presence of some characteristics, however, contributes to the generation of good indicators (Figure 2).

Figure 2 - Characteristics present in good performance indicators

Goals and performance indicators should be reviewed periodically or as changes (in the market or in the operation) suggest revising certain pre-established definitions.

GAIN SHARING (GAINSHARING)

Gain sharing can be understood as a variation of the SLA. In this modality, the contracting party is also provided with an incentive to collaborate to increase the efficiency of the operation. It is a way to further promote good performance.

There are several forms of gain-sharing contracts. In all cases, however, a fixed remuneration portion is defined as a way of guaranteeing the minimum profitability of the contracted party. Differences center on how performance indicators are used.

The most common one provides for the use of service and cost indicators and targets and, as with the SLA, fines are stipulated if targets are not met.

The difference between the SLA and profit sharing is in the division of results achieved in excess, that is, beyond those previously defined as a goal. In this way, the contractor is also motivated to improve the efficiency of the operation.

The great difficulty of this system is in its operation. The way to measure incremental gains and be able to define exactly what is the result of a service provider's action is not always a simple task.

Shared operations add complexity to the gainsharing implementation. An example of this is when the contractor is responsible for transport and storage operations, but all logistical planning is the responsibility of the contractor. Tracking the actions that led to a reduction in the cost of transport or storage can be a complicated task.

The operation's historical data should serve as a basis for understanding the impact of each action on the final result of the operation and for comparisons with future improvements. The reliability and scope of information systems will thus contribute to this end.

As the contractor is responsible for a greater number of activities, the implementation of this form of remuneration also becomes more complex, as it requires a greater level of control. On the other hand, it also has the potential to generate greater returns, since the service provider will be concerned with the total cost of the operation.

But how do you manage earnings sharing over time? This type of remuneration encourages constant improvement. However, it is natural that the first actions generate results of greater impact than actions taken in two or three years of operation.

How to ensure, then, that the operator is well rewarded for initiatives in the medium and long term? There is no definitive answer to this question. What exists are different negotiations. Some contracts stipulate that remuneration for earnings is for life. That is, let's say that the service provider took an action that resulted in a cost reduction of BRL 1 million/year (beyond the target). Let's also say that your share of the gain is 10%. Every year, this PSL will be remunerated at R$ 100 thousand.

Other contracts, on the other hand, provide that the provider is remunerated only on the initial reduction and, thereafter, the target is redefined. In contracts of this type, the chances of the impact of long-term improvements being lower are greater, since the PSL does not continue to be remunerated for the improvements made previously. In this case, after a certain period of time, it is necessary to renegotiate the contract to redefine the share of each person involved in the results obtained.

The implementation difficulties, combined with the need for an excellent communication process between those involved and the existence of a climate of trust and commitment, make this type of remuneration to be applied to specific situations, such as when:

– The contractor has assets dedicated to the operation of the contractor;

– The contractor has a high degree of involvement in the management of the contractor's operation;

– The outsourced operation has a high share of the contractor's logistical costs.

These prerequisites mean that this contracting system is not widely used. In the United States, only 5% of logistics operator contracts only consider gainsharing as a form of remuneration. In Brazil, the degree of use is even lower.

EVIDENCE IN BRAZIL

In Brazil, the use of more “sophisticated” forms of remuneration is still small. Research shows that 91% of logistics service providers charge based on price lists, which represent 82% of their billing (Figures 3 and 4).

Figure 3 - Degree of use of forms of remuneration

Figure 4 - Participation of each form of remuneration in the logistics operator's billing

Another form of remuneration used, based on costs plus margin or fixed fee, is adopted by 38% of logistics operators. It represents only 11% of its revenue.

The use of gainsharing is even more incipient. Only 12% of operators claim to use it and the 2% share in revenue indicates that even those who use it do not do so on a large scale.

The use of more sophisticated forms of remuneration is associated with the size of the operator and the existence of a partnership relationship with its customers. Difficulties in measuring operational gains brought by the service provider encourage the use of gainsharing in situations where there is mutual trust between the parties.

However, despite the fact that 70% of PSLs have contracts with an average duration of over three years, partnership relationships are still uncommon in Brazil. Research results show that 77% of logistics service providers point to cultural difficulties between contractor and contractor as one of the main barriers to the development of outsourcing in Brazil.
 

CONCLUSION

The simplest forms of compensation are not the most appropriate to deal with more complex relationships, where the contractor is responsible for a large part of the shipper's logistical operations, or when the activities for which he is responsible play an important role in the contractor's business ( whether in cost or service level).

For these cases, there are more appropriate forms of remuneration that encourage the good performance of the service provider. Two of these modalities were analyzed: SLA (Service Level Agrement) and gainsharing (Gains Sharing).

In both cases, there is a clear incentive to meet the jointly determined goal or, in the case of gainsharing, to exceed agreed goals. But the complexity of implementing these modalities is also evident.

The use of sophisticated monitoring and control systems and an excellent relationship between those involved in this type of contract are fundamental requirements for the proper functioning of the system.

A reflection of the implementation difficulties can be seen in the low level of use of these remuneration systems, particularly in Brazil. However, there seems to be a tendency towards an increase in its use when we analyze the United States, where the market for logistics service providers is more mature.
BIBLIOGRAPHY

Service level agreements as a contributor to TQM goals; Logistics Information Management; Bradford; 1997; Parish, Robert J.; Vol.: 10, No. 6, pp 284-288

Pitfalls of cost-plus contracts; Traffic World, Washington; Nov 16, 1998; Robert M Spira; Vo: 256, Nº 7, P 34

Logistics Outsourcing: A Management Guide, Council of Logistics Management, Oak Brook, IL, 2000

Clifford F. Lynch;

Research Logistics Operators in Brazil; Research carried out in 2001 –CEL/Coppead and BA&H

Authors: Leonardo Lacerda and Aline Ribeiro