Deconstruct the 3PL Contract to Create Value

3PLWOs offer a number of benefits:

• Bring industry-vertical expertise in warehouse operations, particularly specialized requirements such as cold storage, hazardous materials, alcohol and pharmaceuticals.
• Enable flexibility when launching new products or testing different markets
• Offer scalability up or down for acquisitions, divestitures or spinouts
• Bundled-services discounts from 3PLWOs who also provide transportation and other adjacent services
• Add flexibility to scale with cost-effective, shared-space options instead of smaller single buildings
• Access to best-in-class systems including warehouse management systems, warehouse execution systems, warehouse control systems, labor management systems, order management systems, transportation management systems, etc.
• Mitigate capital investments such as material-handling equipment and warehouse management systems

However, some believe using 3PLWOs increases their risks, such as:

• Ad hoc cost variances, often triggered by frequent procedural changes or high volatility in the client’s business volumes
• Perceived loss of control and flexibility
• Inability to take advantage of incentives offered by states and municipalities
• Poor alignment between the client’s values and 3PLWO, often caused by a lack of performance measures
• If the 3PLWO experiences financial distress and files for bankruptcy protection, the landlord resolution may include accelerated rent, termination of the lease or even access to liquidate the client’s inventory
• Concern for potential damage to customer relationships due to the use of 3PLWOs

Traditionally, 3PLWO providers engage in one of a few optional pricing models with their clients, including cost-plus or “open book” -- the most frequently used pricing model – as well as fixed-fee and activity-based. Regardless, each cost model should be relative to the client’s volume profiles, including:

1. Types of receipts: live unloads, drop trailers
2. Types of receiving loads: pallets versus floor-loaded
3. Receiving unit of measure, e.g., pallets, cartons, or sellable units
4. Putaway and storage unit of measure, e.g., pallets, cartons, units
5. Inventory storage profile: cube, weight, temperature, hazardous, inventory turnover
6. Pick and pack unit of measure, e.g., pallets, cartons, units
7. Manifest and load unit of measure, e.g., pallets, cases
8. Types of shipping loads: pallets versus floor-loaded
9. Transport modes: full-truckload (FTL), less-than-truckload (LTL), parcel, ocean container, air container, etc.

In activity-based pricing, client costs based on negotiated rates may not reflect actual 3PLWO costs; the 3PLWO may lose money on some activities and recoup it on others.

Deviations from the agreed plan can increase or decrease the 3PLWO’s profit margin. Client costs typically vary according to volumes and activity types, which may not be accurate, particularly in early periods of the relationship. In a cost-plus pricing arrangement, client costs are relative to the 3PLWO’s actual costs and based on volume but are less sensitive due to a higher proportion of fixed costs. One common model gives the client responsibility for capital expense components, i.e., material-handling equipment (MHE), systems and potentially the lease, which achieves transparency of labor needs in a cost-plus agreement. In a fixed-cost pricing agreement, client costs vary little unless volume exceeds defined thresholds in a tiered-rate structure.

When the business is committed to having a warehouse in a specific area for an extended period of time, longer than the 3PLWO contract term, maintaining responsibility for the lease may be in the client’s best interest. This provides more leverage during negotiations. If the 3PLWO is not achieving KPIs (key performance indicators) or meeting expectations, the client will have better leverage to encourage improvement. If necessary, the client can replace the 3PLWO, likely at lower transition costs than changing locations, ramping down, moving inventory, and ramping back up in a new location with a new 3PLWO.

Thus, when the term of the contract is longer, it is often more favorable for client companies to be responsible for some contractual elements; with a short-term contract, it is sometimes less desirable for clients to be responsible for some contractual elements (Figure 1).

Figure 1: Contract Elements vs Lease Term

Source: CBRE Research.

For example, the racking, MHE, and automation are often pass-through costs from the 3PLWO to the client. In situations where the client and the 3PLWO create a short-term agreement (less than 2-3 years) and when the agreement is renewed, the 3PLWO will often lease the equipment and renew equipment leases, then pass through the equipment costs of an ongoing lease. In these situations, the client would have been better off spending capital to purchase the equipment, reducing the total cost over the term of the 3PLWO contract.

Conversely, systems may be more dependent upon the client’s IT capabilities, whether the client already has a management system for warehouse (WMS), transportation (TMS), yard (YMS), labor (LMS), order (OMS) or—particularly with e-commerce clients—distributed order (DOM), to minimize split shipments. Even when the client does not have an existing IT platform to run the facility, in situations where the 3PLWO contract exceeds 3-4 years, it may be more favorable for the client to purchase the appropriate systems rather than accept perpetual pass-through costs from the 3PLWO.

When the 3PLWO is diversified and provides other services outside the four walls, such as transportation, the client company may gain additional leverage to negotiate discounted costs. Figure 2 outlines additional considerations for the real estate strategy, whether direct landlord lease or 3PLWO-provided space.

Be aware that 3PLWO agreements may contain embedded leases, in situations where the 3PLWO is responsible for the lease. Embedded leases should be accounted for in accordance with FASB accounting standards--whether the embedded lease covers real estate, equipment or both--which typically includes recording a right-of-use asset and a lease liability on the client balance sheet. The right-of-use asset is then amortized over its useful life, and the asset liability is reduced as payments are made.

Figure 2: Direct Landlord Leasing Creates More Value Compared to 3PL-Provided Space

Source: CBRE Research.

In the past, companies that chose to outsource their warehouse operations often allowed the 3PLWO to manage it all. Today, savvy companies are becoming more aware of where savings in the 3PLWO contract can be achieved and when to maintain responsibility for certain contractual elements that may offer financial benefit and control over desired performance outcomes or leverage in negotiations.

CBRE Supply Chain Advisory (SCA) is a global supply chain consulting organization founded to help occupier and investor clients solve business problems at the intersection of supply chain and real estate. Areas of solutions and expertise include supply chain strategy, supply chain network design (SCND), facility concept design (FCD), operations assessment, capacity analysis, 3PL selection, discounted cash flow analysis and logistics comparative analysis for investors.