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Supply Agreements: Volume Estimate or Purchase Commitment

When entering supply agreements, buyers and sellers have different interests around the volume of goods to be purchased or supplied.  A buyer wants maximum flexibility on the volume of goods it will order, while seeking favorable pricing and security that the seller can provide the volumes the buyer needs.  A seller, on the other hand, wants the buyer to commit on the volumes it will purchase, so the supplier can plan its production, ensure predictable sales, and align pricing with volumes.

The purpose of this article is to address these different views on volumes and summarize each party’s perspective. The table below lists key topics of interest for buyers and sellers with respect to volumes. It shows how each party might address them in a contract to support their respective interests.  Ultimately, what is drafted in the contract will be the outcome of negotiations between the buyer and seller on these volume-related issues.

blank Jana King Allen

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jana.kingallen@loganpartners.com

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Volume Estimate vs Purchase Commitment

Buyer Seller
  • No binding commitment on volumes of goods to be ordered
  • Can provide volume estimate, but it is not binding [Volume estimate is estimated requirement for Goods that buyer expects to purchase from seller over a set period of time (e.g., monthly or yearly volume estimate).]
  • Prices valid for set period of time, regardless of volumes ordered
  • If volumes are binding, buyer should have ability to change it for certain circumstances, such as:

o   goods supplied don-t comply with specifications or other contractual requirements

o   other factors impact volume/forecasts (e.g., a change in regulation that impacts demand for goods, end/customer demand falls significantly, buyer changes its business plan)

  • Require binding purchase commitment from buyer
  • Require minimum quantity of goods or spend per order
  • If volumes are not binding, then:

o   Tie pricing to amount of volumes ordered

o   Seller has right to change pricing if certain volumes not met (i.e., change pricing if volume estimate/market share not met)

o   Seller has right to extend length of contract if certain volumes not met during initial term

o   Orders can’t be cancelled or buyer must pay non-recoverable costs of order

 


Market Share

[Market share is a % of buyer’s overall net requirement for goods in a market that is given to seller, e.g., 80% market share in EU means buyer purchases 80% of its widgets for the EU market from that seller, and buyer purchases remaining 20% of widgets for the EU market from other suppliers.]

In calculating the net requirements this would be what buyers actually purchase and receive

Buyer Seller
  • Can provide market share to supplier but should not be binding
  • Buyer has ability to change market share for certain circumstances, such as:

o   goods seller provides aren’t complying with specifications or other contractual requirements

o   other factors impact volume/forecasts (e.g., a change in regulation that impacts demand for goods, change in buyer’s business plan)

  • If market share is binding and buyer converts it into volume estimate (for supplier’s production planning purposes), the corresponding volume estimate should not be binding
  • Require market share to be binding
  • For production planning purposes, market share should be converted into a corresponding market estimate, so seller knows the number of goods this would correspond to
  • Process/procedure for auditing market share – buyer total spend/orders in market versus actual orders received by seller

 


Tolerance Level

(For volume estimate and/or market share)

Buyer Seller
  • Include a tolerance level for the market share or any volume estimate. A tolerance level is an acceptable variation in quantity ordered versus the estimate (e.g., +/-3%)
  • A tolerance level is especially important if any volume estimate/market share is binding.  It protects the buyer if it orders less or more than volume estimate/market share
  • Have narrow band of tolerance with respect to volumes buyer will order
  • Tolerance level needs to be tightly defined and ideally a worked example provided

 

Order Modification

Buyer Seller
  • Right to modify or cancel order up until delivery without any liability to seller

 

 

  • Buyer should notify seller of cancellations/modifications to order within agreed period (should be a limited/short period)
  • Ideally orders can’t be cancelled once placed
  • If production already started when buyer notifies supplier, then buyer should be pay for goods already produced, and raw materials ordered and other non-recoverable costs

 

 

Securing Production/Production Planning:  Rolling Forecast

Buyer Seller
  • Rolling forecast should not be binding and not be construed as minimum purchase obligation
  • Right to review rolling forecast and any volume estimates or market shares granted to seller:

o   on a regular basis ideally quarterly at least annually

o   in event goods seller provides aren’t complying with specifications or other contractual requirements

o   if other factors impact volume/forecasts (e.g., a change in regulation that impacts demand for goods or change in buyer’s business plan)

  • Require buyer to submit rolling forecast of volumes to cover an agreed period (e.g., monthly 6 month rolling forecast)
  • If amounts buyer orders don’t meet rolling forecast for a specific period of time (e.g., for 3 consecutive months), then seller can re-adjust prices to reflect amounts ordered
  • Allow for seasonality effects on production output i.e. may be certain periods where output is lower due to holidays or summer period or planned maintenance

 


Securing Production/Production Planning: Production Capacity

Buyer Seller
  • Require seller to guarantee a minimum annual production of volumes
  • Require supplier to warrant it has production capacity to fulfill all orders up to an annual volume capacity
  • Require supplier to warrant it has production capacity to meet a supply contingency above the annual volume capacity (e.g., annual volume capacity +5%) to account for unanticipated volume increases
  • If seller has to make a warranty regarding production capacity, the warranty should not apply if certain events occur, e.g., if supplier can’t get raw materials
  • Ensure annual volume capacity is achievable; if agreeing to supply contingency, it should be a low %

 


Securing Production: Contingency Plan

Buyer Seller
  • Require seller to have contingency plan demonstrating how it will secure continuous supply of goods to buyer and handle supply constraints
  • This may include alternative production sites in different geographic locations. Alternative productions sites should meet buyer qualification standards for production facilities
  • No additional costs to buyer for production from other sites
  • Availability of key raw materials, stores in specified warehouses in different locations
  • Contingency plan should account for needs of various buyers on best efforts basis, but seller has full flexibility to determine who is supplied first or in which sequence

 


Supplier Inability to Meet Volumes

Buyer Seller
  • If seller can’t meet volumes in an order or forecasted volumes, it should give buyer action plan of how it will rectify this
  • Seller should give preference to buyer’s orders over production for other customers
  • If seller can’t meet volumes, buyer can purchase substitute goods from other third parties without liability to seller—any such purchases should count toward any purchase commitment buyer has made with seller
  • If trouble meeting volumes in an order, work with buyer to agree on alternative dates for delivery
  • Don’t agree to give preferential treatment to buyer’s orders

 

 

Safety Stock

Buyer Seller
  • Require seller to guarantee having a minimum amount of stock of goods (or their raw materials) on hand to ensure buyer can get amount of goods needed in event of higher demands
  • Seller should keep stock close to factory/warehouse and store per industry standards
  • Safety stock kept in different geographic locations
  • Key materials list subject to regular updating based on buyer’s requirements
  • Ensure flexibility on where safety stock can be stored (e.g., don’t have to keep it on -site; can get stock from affiliates)
  • Cost of carrying safety stock paid for by buyer
  • Buyer must purchase safety stock at end of contract or obsolete safety stock periodically
  • Safety stock can be rotated in and out
  • Items contained in safety stock subject to review

Featured Image by Angelique Johnson from Pixabay

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