How to mitigate costs when modifying or cancelling a Purchase Order
As we covered in the first of this two-part article on Purchase orders, poor supplier performance can result in significant (10-20%) indirect costs. However, by applying certain risk management practices to your operations, you can reduce your risk significantly.
If you’ve done proper planning and have included the four key supply conditions to protect your company in case of errors and defects, delivery delays, force majeure events and changes in business plans, you’ve gone a long way to protect your company and minimize any financial or legal headaches.
So, in this second part, we focus on the costs associated with modifying or cancelling a purchase order (PO). What type of costs would you incur if you cancel or modify a PO or cancel a binding supply agreement? And how should you mitigate this cost?
First, you should safeguard against being overcharged for the cost of materials not allocated for your goods and from any indirect and consequential losses arising from the cancellation of the PO or supply agreement. Your company must also have the option to exit the PO before production starts. It is important that you cover all possible circumstances that lead to cancellation costs when you draft the terms and conditions of a supply agreement, including any specific rights and obligations of the parties. By including the following terms in the supply agreement, you can reduce cancellation costs and losses.
Once of the major reasons for a buyer to stop a binding supply agreement is a change in consumer demand for the company’s goods or a change to their business plan. This kind of termination is typically called ‘termination for convenience’ and exercising this right is a costly affair.
If you cancel a supply agreement for convenience and not for breach or other performance related issues, you are responsible to pay reasonable cancellation charges towards production costs that the supplier has already incurred. These cancellation charges include the costs of already-completed goods, components of goods, raw materials, work-in-process inventory and costs directly incurred by the supplier due to the cancellation of binding third party contracts entered by the supplier solely to produce your goods (cancellation charges). Before paying cancellation charges, you should ensure that these materials were allocated by the supplier towards production of your goods alone and not distributed for third party production.
The supply agreement should specify the buyer’s obligation to pay cancellation charges to the supplier if the buyer opts to end the agreement for convenience. If this is not the case, the buyer’s obligations to pay cancellation charges will have to be negotiated. This could result in a costly and lengthy litigation of the buyer’s actual liability unless an amicable resolution can be reached. Typically, in such cases, the supplier would give a detailed list of all cancellation charges, documentation or evidence related to the payment of such cancellation charges and any other information which is reasonably requested by the buyer. This process will ensure transparency and reasonable costs for the buyer and avoid any overcharges for unrelated materials.
Cancellation before and after the start of production
Normally, in a supply agreement the buyer has the right to cancel a PO within a certain number of days of issuing the PO. This is the period during which the production process has not yet started. Therefore, you can exercise this exit option without attracting any liability (zero-liability period).
If you do not cancel the PO within the agreed zero-liability period but cancel it after it is over, you must pay for materials specifically bought to fill the order, as well as manufacturing costs directly incurred before the order was cancelled. So, it is crucial to be diligent in issuing a prompt notice of termination to the supplier before the zero-liability period is over to avoid any unnecessary liability.
In some exceptional cases, the supply agreement might allow you to have a flexible zero-liability period, ending a month or so prior to the delivery date. The more flexible the exit option, the easier it is to manage your liability; therefore, you benefit when including a moderate exit option in your agreement.
In case of bespoke goods, your liability for cancellation charges due to termination for convenience, or termination after production has started is particularly harsh due to the customization. This is not the case if the goods are standard off-the-shelf products which can be easily resold by the supplier.
Exclusion of indirect costs
Cancellation charges that can be linked to or are directly attributable to production are classified as a direct liability. Any other costs that are not readily or directly assignable to the goods are indirect and consequential liabilities.
Your supply agreement should specifically exclude any indirect liabilities that arise due to termination of the supply agreement or the PO. The Supplier may push for certain costs to be considered as direct when these could be indirect costs. Some examples of such indirect costs are, profit which the supplier would have made on the completed order, restoking charges, reallocation charges, or cost of re-deployment of employees, tools and machinery.
No liability for PO termination
The buyer will not be liable in case the supply agreement or PO is terminated for a supplier’s breach, including errors or defects detected during inspection, quality and performance-related issues. If termination occurs because of a force majeure event, then neither the supplier nor the buyer is liable for costs related to performance or delivery of the goods. The buyer’s only remedy would be to reallocate volumes to third party suppliers until the event is over.
There are the costs associated with cancellation, or modification of a PO: cancellation charges upon termination for convenience, and cancellation charges after production starts. You are not responsible for costs related to termination of the supply agreement for a supplier’s breach or if a force majeure event occurs. These are important rights and must be contractually agreed to mitigate and manage your liability and shield you from unnecessary financial exposure. Note: This is the second part of the two-part article. The first part discussed the circumstances that allow a buyer to modify or cancel a purchase order. This second part discusses the costs associated with such modification or cancellation of a PO and supply agreement.
Note: This is the second part of the two-part article. The first part discussed the circumstances that allow a buyer to modify or cancel a purchase order. This second part discusses the costs associated with such modification or cancellation of a PO and supply agreement
Illustration by Usha Kumar