This article discusses pricing mechanisms for outsourced warehousing contracts. The three main types of pricing mechanisms are percentage of sales, cost plus, and rate based. Percentage of sales ties the fee to product sales value but may not relate to actual costs. Cost plus declares costs and adds a profit margin but can overstate resources. Rate based establishes fees for each activity based on detailed analysis of costs and is generally best. Gain sharing and performance-based logistics are also discussed as ways to incentivize cost savings and good performance. Careful planning, communication, and cost analysis at the contract design stage are emphasized as critical to developing an effective pricing mechanism.

1. Article - Outsourced Warehousing - Pricing Mechanisms
This short article may be of interest. Or at least it might generate some discussion!
Warehousing Contracts – The Options
Introduction
The outsourcing of Logistics services continues to be a growing trend, and can
encompass a very broad range of services. This article will focus only on outsourced
warehousing contracts, and is intended to be a guide for those companies considering
the outsourcing of warehousing or indeed those companies that may wish to review and
renegotiate existing warehousing contracts.
The specific focus of this article, is on traditional Third Party Logistics (3PL) contracts and
the types of pricing mechanisms available for use within warehousing contracts, and
does not cover other very important aspects such as:
Planning and management of the selection process.
Contract negotiation.
Implementation and ongoing contract management.
Outsourcing Logistics services continues to grow globally and probably now stands at
about 85%
The reasons for this growth are many, but primarily, that Logistics Service Provider’s
(LSP) customers believe they will gain benefits such as these shown here.

2. Whilst reducing cost is generally a major objective in outsourcing, it may often not be
achieved, as simplistically, it may not be possible for the LSP to carry out the same
operation as the customer currently conducts in house, at a reduced cost, whilst also
making a profit margin.
Where the existing in-house operation is very inefficient, inappropriately resourced or
could gain significantly from being incorporated into a larger operation, then of course
savings may be possible.
From this point on, when referring to outsourcing, it is the outsourcing of warehousing
only that is being referred to.
The primary benefit of warehouse outsourcing should probably be thought of as gaining
flexibility. This can relate to being able to handle peaks and troughs in demand,
acquisitions, geographic and product line expansion and the like.
A critical stage in the outsourcing process is the structure of the contract and in
particular the pricing mechanism. Research has shown that up to 80% of Supply Chain
costs may be locked in at the design stage of the Supply Chain. So reducing costs post
implementation can be very difficult.
Most of the post implementation problems that LSP customers face can probably be
traced back to poor contract structure and negotiation. It is the contract and the joint
process of constructing the contract that will set in place the expectations of both parties
and of course the drivers of behaviour.
Typical post implementation issues can range from poor service to increasing costs,
often all put down to the non disclosure by the customer of critical information.
Cost v Price
One of the key aspects of structuring a contract is understanding the resources and
hence the costs involved in its performance. This is best achieved by open discussion
and analysis of the activities and product volumes involved. Storage requirements at
various times through the year are one element, but the detailed picking, packing and
despatching activity can be a significant cost driver. Detailed information on SKU (Stock
Keeping Unit) numbers, size and weight are important, as are the details of past and
forecasted order profiles, right down to order line items.
This level of detail enables the LSP to profile the number of pick locations required, and
the actual number of picks being made, on a SKU by SKU level. Accurate calculations of

3. storage and handling equipment needs as well as labour requirements can then easily be
established, which all underpins more accurate contract costing.
With a high degree of confidence in the resources required and hence the costs involved
in providing the service, it is then a comparatively easy step to structure the commercial
framework of the contract.
Each Parties Objectives
It is not uncommon, for each party in an outsourcing contract can have objectives or
agendas that conflict. A well constructed contract and pricing mechanism will go along
way to mitigating these potentially conflicting agendas.
Agendas - Customer
To reduce operating costs
To reduce capital requirements
To improve service
To gain specialist skills/technology
To outsource 'difficult' processes
Agendas - LSP
To
To
To
To
To
make a profit
better utilise existing assets
leverage existing skills / IT
enter new markets & gain new sills
gain new customers and up sell services
Potential Dangers - Customer
They may try to squeeze the 3PL too much on price
They may not fully declare problems in the operations
They may not fully understand the 3PL’s capabilities
Potential Dangers – LSP
They may under-price the contract
They may propose inappropriate resources
They may lack specific/industry skills and/or experience
General Principles
There are some general principles and considerations that should be accounted for in
structuring the commercial part of the contract. These will include the following:
1. The LSP will require a base level fee, or agreed minimum level of income
that is not volume related, in order to cover some fixed costs. To do
otherwise exposes the LSP unfairly.
2. The fee for service paid, should fairly reflect the resources required and
costs being incurred by the LSP.
3. The fee structure should encourage improved service performance.
4. The fee structure should encourage a cost reduction culture.
5. The fee structure must be sustainable, through changes in the customer’s
operating environment.
6. The LSP should have the opportunity to improve profit margins through
adding value and innovation beyond the basic services required.
Sadly, many companies approach a LSP contract as procuring a commodity and the over

4. riding goal becomes the achievement of the lowest possible unit cost. This approach can
be extremely counter productive and costly in the longer term.
Types of Contract Pricing Mechanisms
There are broadly three types of contract pricing mechanism that can be used, with
variations that can be bolted on. These are:
Percentage of Sales. Whereby the LSP fee for service is based upon an
agreed % of the sales value of the product handled.
Cost Plus. Whereby the LSP declares what resources and costs are required
to conduct the service and an agreed profit margin (the plus) is added.
Rate Based. Whereby a rate or price, is agreed for each of the activities and
services to be performed.
Variations that can be applied to these basic contract forms can include:
Gain Sharing. Whereby cost savings initiated by the LSP or customer will be
shared.
Performance Based Logistics (PBL). Whereby fees or more likely contract
profitability, are directly linked to agreed performance targets.
Percentage of Sales
This type of contract is still widely used, particularly with distributors rather than LSPs. It
might be considered as a rather ‘lazy’ approach by the customer to contract pricing, as it
may bear no relation to the resources and costs of the services being provided. The
greatest criticism of this type of pricing is that it offers no benefit to the customer should
volumes increase, and the LSP benefits from economies of scale. The reverse is also true
of course.
Where this form of pricing is used, it is important to establish limits or parameters to the
service that will allow fee percentages to be adjusted if required. It is also vital that the
customer is involved in the analysis of the resources and hence the costs required to
perform the service. Traditionally, the customer has often not been included in this
process.
The actual percentage charged can vary significantly from industry to industry, and is
obviously heavily dependant on the value of the product being handled. But wide
variations within the same industry have been observed and would tend to indicate that
the percentage charge established may in some cases not be related at all to the cost of
the service being provided, but more aligned with what the market will bear.
Positives
Fees are known and easily forecasted
Negatives
Fees may bear no relation to the resources/effort required
Fees can become inequitable should product range change
Fees can become inequitable should order profiles change
Fees can become inequitable should volumes change

5. Cost Plus
This form of pricing is still widely used and is favoured by some of the major LSPs. It can
tend to favour the LSP rather than the customer and may lead to contracts being loaded
up with resources that are not really required or at least not fully utilised by the contract
concerned. It can also drive undesirable LSP behaviours in that for the LSP at least, a
situation may arise in a poorly constructed contract, that the more resources that are
consumed, be that storage space or labour, the better.
In its favour however, this form of pricing can often be the only way of pricing a contract
at least in the short term, where it may be very difficult to establish the precise services
required or the detailed volumes and order profiles to be handled. This could be the case
for example in a new business start up, entry into a new market, during an acquisition,
following a major new product introduction and the like. However, it is recommended
that the pricing mechanism be moved to some form of rate based fee as early as
possible.
Positives
Useful where services and volumes are uncertain
Negatives
Harder to incentivise LSP
Can lead to over resourcing of contracts
May lead to LSP focus on maximising storage & activities
Rate Based
A rate based fee structure tends to offer the best mix. This is due to the detailed work
required to establish the rates and also the volume related break points that should also
be incorporated. It should result in a fee for service that fairly reflects the work being
carried out, as well as protection for both parties, should the customer’s business
change, in relation to volumes or order profiles. These types of change can have a
significant impact on the LSPs resource needs and costs.
The basis of this pricing mechanism should be an open and shared analysis of the
activity to be carried out and the resources required to provide the full range of services
required. Often, a fixed monthly fee is utilised to help offset the LSPs fixed costs, with a
variable fee structure then being applied for the various activities being carried out.
These activities might include receiving and putaway, picking, despatch and the like,
with different rates being applied for unit, carton and pallet picks.
Consideration must be given to the impact of increases or decreases in storage needs, in
throughput volume and changes in the picking profile. All of these can be adequately
catered for within the fee structure if based on sound analysis, forecasts and fairness.
Positives
Fee reflects work being done
Fee can cater for changes in throughput and profile
Both parties are protected against impact of task change
Negatives
Requires effort and openness to build the rate structure
Gain Sharing
A gain sharing formula can be applied to any contract type. The basic concept is that

6. should the LSP, or indeed the customer, identify opportunities to improve the operation
and reduce costs, that those cost savings should be shared. The exact percentage split
of the saving is debatable, but it could be argued that 50/50 is the fairest.
Without some form of gain sharing incentive, there may be limited ways of encouraging
innovation and cost saving within the contract. In fact it could be argued, that without
such a formula, there is a disincentive for the LSP to seek performance and cost
improvement.
Performance Based Logistics (PBL)
Performance Based Logistics or PBL is a term that has evolved from the US Defence
industry, and as the term suggests rewards and penalises the LSP based on performance
against agreed service targets. It should not be seen as yet another adversarial means
of managing an LSP, but as a genuine means of encouraging and rewarding superior
performance.
This pricing approach will generally be structured so that the LSP’s profit element can be
increased or decreased, rather than attacking the LSP’s total income. In this way the
right performance is encouraged, without openly putting the LSP’s business at risk. An
escalation clause would also be used, so that repeated performance below agreed
targets, would at some stage then start to erode base fees, not merely profit margins.
But appropriate review and mediation clauses should avoid this point being reached.
Summary
In summary, this article has attempted to highlight, albeit at a high level, the range of
common warehousing contract pricing mechanisms that can be utilised, and some of the
advantages and disadvantages of each. Which ever pricing mechanism is used, an
effective pricing mechanism must be based on detailed factual information, particularly
regarding customer product volumes and order profiles, as well as a willingness for joint
resource planning and contract costing. (This would normally take place after an LSP has
been short listed for a contract).
Considerable experience has shown that the failure of pricing mechanisms and often the
inevitable contract failure can usually be traced to poor planning, communication,
resourcing and costing, right at the start.
Bearing in mind that 80% of Supply Chain costs can be ‘locked in’ at the design stage
(see Introduction above), this phase of outsourcing can prove to be the most critical.
On a final note, whilst this paper has been focused on the establishment of new
warehousing contracts, it is not impossible to also review and revise existing contracts
and pricing mechanisms.