Business law in real life
Buy what you want
and not what the seller
wants to sell to you
The decision to invest in your production facility comes with many and difficult issues. Over the years, we have, together with our clients, developed approaches and contractual techniques that we call “functional procurement”.
The main purpose is to consistently contract precisely the functionalities aimed at by the investment, rather than lists of components and work performed. Below, we describe a few key elements, based on a business case from the process industry.
One of our clients, a Swedish company in environmentally sound recycling of packaging, needed to do a major upgrade of their existing industrial plant in terms of capacity and quality of output fractions. The investment would be done in existing premises, using existing production lines as a basis, and with minimum disruption to operations. The investment included advanced sorting technology as well as construction elements and control systems (to be integrated with the existing plant).
Many issues to decide on
Company management faced a number of decisions. How much would be handled internally and how much would be procured from suitable suppliers? If deciding on a trades contract, who would be responsible for coordinating the various elements and how would finger-pointing in cases of delays or unwanted outcomes be avoided? If choosing a turnkey contract, how much can and should the procurer get involved? How would goal achievement of the investment be measured and assessed? And not least, how would costs be controlled to avoid paying extra for things believed to have been already paid for?
In this case, the company decided on a principal supplier from a European company, specialising in sorting technology. For practical and economic purposes, the construction contract was procured by a local actor. The control system, which needed to be the same as the one already used in the plant, was supplied by a German company. The client would handle some of the simpler elements, by themselves or with the help of local craftsmen. Legally, this was a matter of a trades contract, which traditionally requires a great deal of coordination and puts a lot of responsibility on the client.
Appoint someone principal supplier
Using the appropriate techniques, even a trades contract can be designed to practically resemble a turnkey contract. One of the suppliers, in this case, the sorting technology supplier, is assigned the responsibility of “principal supplier”. The principal supplier is given opportunity to study the operating environment and conditions on site, as specified in the contract. Some of the other suppliers, in this case the control system supplier, can be assigned sub-suppliers.
The principal supplier can be given a special coordinating responsibility to specify the relationship with other suppliers as well as the client. Using techniques of this kind gives the principal supplier a role similar to that in turnkey contracts.
Decide on what is to be delivered
A common issue of disagreement in construction contracts that are not turnkey contracts is the issue of what is to be delivered. Client expectations on certain “solutions” are easily reduced to technology-driven lists of what is included in the delivery; machines, components, and a number of engineering hours for installation and commissioning. Everything not explicitly listed will during the project be considered additional work requiring special compensations.
To avoid endless discussions on this and to create better cost control when investing, we prefer to work with guaranteed functionalities.
In this case, the expected functionalities of the upgraded plant after completed delivery were carefully defined. They involved a combination of capacity (processing amount handled by the plant), availability (maximum downtime allowed), quality (measured on output given certain inputs), and replacement (scrap allowed). All functionalities were specified to make them fully measurable. Measuring methods to control guaranteed functionalities were described in separate contract appendices.
Consistent management required
A functional procurement must be consistently managed throughout the entire investment process. The decision process should include decisions by management on what functionalities are invested in and what cost limits apply. The foundation of a functional contract is then prepared in the contract documents where the client clearly states what he wants a tender for; namely specified functionalities under specified operating conditions.
During the contract and negotiation phase, everything is consistently checked against the procured functionalities. Focus is also put on whether agreed functionalities are actually maintained throughout the entire warranty period.
Responsibility requires freedom
A common question is how much a client can get involved in the contract work without undermining the principal supplier’s responsibility for contractual functions. In this case, our client had a great deal of knowledge and many thoughts on technical solutions. Since functionality is what the client pays for, and not technology, the supplier must be allowed main responsibility for how the contract is performed and how problems are dealt with – based on the client’s technical specifications, of course.
In our experience, there is some room for the client to influence the process without taking over. But it has to be in agreed form and clearly formulated in the contract.
Schedules must be kept
Facility investments often involve special demands on maintaining time schedules. In this case, it was of particular importance in order to avoid disrupting operations.
A good technique to promote punctuality in delivery is to let the principal supplier present a time schedule, which is checked with client operations and then guaranteed by the supplier.
The schedule must include not only mechanical operation testing but also sufficient time for functional testing, including availability tests, which often require a certain amount of time when conducted in full-scale production. Only upon completing these elements can delivery be considered complete.
A noticeable penalty for delays is then linked to the set delivery date. If earlier production is of interest to the client, positive incentives in the form of a bonus for early delivery may be included.
Payment upon actual delivery
Supplier tenders are often based on front-end payment plants, in which the supplier has received most of the payment long before testing and commissioning the investment. Functional procurement is based on a different logic; namely that most of or at least the largest payment is made only after agreed functionalities are actually delivered.
Typically, as in this case, we also make sure that there is a payment that isn’t paid until a new test has been successfully performed upon warranty expiry or at least well into the warranty period. Security can also be created by adding VAT for the entire delivery to the final payment.
For a functional procurement to have its intended effect, a functional contract based on the same idea must be produced.
It’s also important that tender appendices (often standard terms and lists of technical solutions) are handled carefully, so that they don’t change or at worst “cancel out” what the client wants to achieve with their investment.
The result: a successful project
The effect of functional procurement in this business case was that our client received, within the specified budget and with no surprise costs, an upgraded plant with specified functionalities without additional work throughout the entire warranty period.
The legal techniques may require some thought, but the logic is pretty simple: better to buy what you want than to settle for what the supplier wants to deliver.