Good ethics makes for good contracts.

Seven Common Technology Service Misrepresentations and How to Monetize Them.

At the IACCM Conference in Phoenix, I participated in a Panel discussion about the role of Ethics, Morality and Fairness in Contracting.  The most common question that resulted was practical – how does one monetize good ethics?

The following are examples from my particular expertise in break-fix service agreements where OEM  (Original Equipment Manufacturer) marketing tactics, lovingly known as FUD (Fear, Uncertainty, and Doubt), are deliberately deceptive and therefore not good ethics.  Many of these tactics have become enshrined in terms and conditions so commonplace they are glossed over as “standard”. 

Once exposed, monetary value can be assigned to the opportunities that are unleashed.  OEMs that do not engage in these ethically shabby tactics then have quantifiable advantages over competitors.   Those that resist can be avoided, or pricing adjusted in compensation for quantifiable restrictions.

Deceptive Marketing of Extended Warranties.

This isn’t about the Big Box Retailer upselling an extended TV service contracts, or an Auto Dealer upselling “undercoating”, but the deliberate presentation of extended warranties as “standard” when in fact the true warranty term is brief.  

Buyers should care because these constructed agreements are entirely to the benefit of the OEM and not the end user. Longer term warranty services effectively dissuade end users from even considering service alternatives, thus removing competition in pricing.  It is also the case that warranty services are rarely negotiated aggressively so the pricing behind the agreements is always a honey pot for the OEM. 

A very common example is a technology purchase where the “standard” warranty is presented as parts and labor for 3 years. The procurement team negotiates the service level agreement and the discount off list price, but is not offered the option of the basic warranty.  Most end users and also most sales representatives do not understand that this longer warranty is a by design a lucrative pre-paid services agreement feeding the services arm of the OEM. The basic warranty it intentionally short so as to allow the OEM to recognize the revenue from the sale as quickly as possible.

Monetizing Tip:

Demand disclosure of the true warranty period associated with the sale. Negotiate any post-warranty coverage as you would any stand-alone services agreement.

1.      Warranties In Lieu of Quality

The best warranty would be for equipment that never broke, rather than a long warranty for a product prone to failure.  Technology warranties are a wonderful foil for deflecting concern about product reliability, since offering a “generous” standard warranty takes the issue off the table.  The thought process is that since the OEM is taking care of the equipment, there isn’t any reason to think further.

Incorrect assumptions about warranty hide very real problems that should be monitored aggressively by equipment owners. So long as an OEM can market an extended service agreement for themselves to fix problems that shouldn’t happen, then they are very happy.

Users should not be complacent about needing to buy service contracts. Failures of equipment are often exceedingly costly.  High availability is currently being achieved not through high reliability but through redundancy.  In these cases, equipment warranties are being used to hide failures which must be measured in order to be managed.

Monetizing Tip:

Monitor equipment failures and compare to the pricing of the services performed.  Extravagantly lucrative services contracts can be brought to light and negotiated.  Practical alternatives can be seriously considered based on rationalizing services pricing to service need.  Considerably more on this subject is available at www.tektrakker.com

2.      Failure to Publish Warranty Reserves

Reserves for warranties are required to be published in financial statements as manufacturers offering warranties must show stockholders how much money is associated with the future services obligation as distinct from the profit from the sale.  There is a publication devoted to digging up the warranty reserve information for manufacturers in general on the web at www.warrantyweek.com. 

Revenue recognition for the full value of sale does not include the reserve, so warranties are always short to maximize rev-rec.  There is an observable trend of companies skipping this requirement which is not just unethical, but also in violation of US FASB rules if not laws.  The absence of a published reserve (excepting products with a 30-day warranty) is an indication of either intention deception, or outright incompetence.  Neither reason is flattering.

Monetizing Tip :

Warranty reserve information is a powerful negotiation point. If an OEM sets aside 4% of the equipment cost for delivery of a 1 year warranty, then additional years of warranty would be logical at the same rate.  This is an excellent starting point for a warranty uplift discussion.

3.      Undisclosed Service Team Sub-Contracting

Most OEMs market their hardware break-fix service as superior based on their specially trained and uniquely qualified technicians. This is hogwash because most OEMS routinely subcontract for technicians from independent service providers – the very same types of providers that they argue should not be used.  

It has also been the trend for over 40 years that products are designed for less and less complex service in the field.  This has supported the dispatch of low-level technicians with parts to swap at dramatically lower net cost to the OEM.   Claims of superior support should be investigated regardless of the name of the OEM.

               Monetizing Tip:

Cut out the middle man and deal directly with the service providers.  Disclosure of the nature of the sub-contracting should be made clear and the service level agreements adjusted accordingly. One should always know the layers of margins involved in these agreements.

4.      Restricted Access to Parts, Diagnostics, and Microcode

The largest difference between the products which can be effectively serviced by an ISP and not the OEM is access to parts and diagnostics.  OEMs manipulate access to parts and diagnostics in order to prevent competition for their lucrative service contracts. Restrictions on access to parts and diagnostics also extend, incredibly, to the equipment owner.  This is akin to buying an automobile and then being denied the option to purchase parts at the Dealer, auto-supply, or internet.   

Access to microcode and other types of non-licensed code (see below) is also frequently restricted by the OEM as another compulsion to buy service exclusively from the OEM. 

Monetizing Tip:

Insist on ready access to parts, diagnostics and microcode as the equipment owner and designated agent. The OEM should not be permitted to your block access to any of these purchased items.  If the OEM claims that such items are unavailable as their Intellectual Property (IP) – see below.

5.      Confusing Tangible Hardware with Intellectual Property

The intersection of the totally separate worlds of tangible hardware and intangible software is colliding inconsistently in the treatment specialized bits of code that are embedded in hardware.  Several major technology vendors have bamboozled buyers into accepting that their hardware is their IP as well as their licensed software.  These vendors have their end users caught in a contractual trap which is both illogical and unethical.

Technology hardware is tangible. Buyers of hardware can turn around and sell their equipment. They can borrow against it. They carry insurance to replace it.  They report on hardware in their financial statements as a capital investment and take depreciation.  Software is intangible and licenses cannot be sold. One cannot borrow against a license. 

Escaping the trap will yield enormous benefits including supporting the residual value of owned equipment, improving finance options and prices, and removing the monopolistic lock of OEM control of services pricing.  These deceptions run deep and require a dip into the details of how hardware and software interact at the machine level to understand.

a)      There are very few true custom products with proprietary hardware.  The vast bulk of electronic products today are assemblies of off-the-shelf parts sourced from all over the world to a set of specifications. The most proprietary part of the hardware design is often the plastic case.

b)      Hardware much first start up before any operating systems (Windows, Unix, Solaris) can be loaded. This is the job of specialty code called variously Firmware, Microcode, BIOS, imbedded code, onboard code, etc.  They all share the characteristic of being shipped standard with the hardware without licenses.  For ease of discussion we call this “Non-Licensed Code” or “NLC”.  

Without NLC, the machine doesn’t work. It has been understood in almost all areas except IT products that whatever makes the machine work is part of the machine. Programmable dishwashers do not have a software license agreement, nor do appliance manufacturers sell software services agreements separate from hardware warranties.  Within the IT environment the treatment of similar code is both inconsistent and illogical.

Hardware “IP” claims for assembled products are weak, if not outright deceptive, on several levels.  

·        First – most NLC is provided by parts suppliers, such an Intel, and such code is intended to be transferrable as part of the hardware.  If any claims would be valid for IP, it would be for the IP of the parts manufacturer. 

·        Second – the process of assembling parts in China does not add IP any more than an assembly line in a Ford plant adds IP to the vehicle.

·        Third – OEMs claiming hardware IP are not disclosing the terms under which the hardware IP can be used in a license agreement – thus the term “Non-Licensed Code”.  

Thus, if a hardware product is IP, then it isn’t tangible and cannot be treated as anything other than a license.  Many “appliance” type products fall into this category but are being mis-represented by vendors as hardware, and then dangerously categorized in financial statements as hardware.  

               Monetizing Tip:

Legitimate IP must be disclosed and documented in a license agreement.  Any remaining NLC should be clearly part of the hardware and readily transferrable.

6.      Firmware/Microcode “Upgrades”

OEMs often lockout access to updates to NLC using the spurious claim that such updates are “Upgrades”.  This is also hogwash – since firmware is never upgraded – only fixed.  The only reason to make such lockouts is to force end users into break-fi x and support agreements which they would not otherwise want or need.

Firmware are the instructions built into the hardware (thus the word “Firm” as in “Tangible”) in order to make it run according to the specifications. Parts manufacturers provide patches (fixes, or updates) to firmware to resolve specification issues.  This is akin to the automobile recall where vehicles with known flaws are voluntarily repaired at no charge to the owner outside of the warranty agreement.

Upgrades to functionality are provided with enhanced versions of the product and are marketed as such. Manufacturers do not give away their upgrades any more than Ford gives away leather in a car if cloth seats were damaged and the vehicle was under warranty.

Monetizing Tip:

Differentiate between patches and upgrades in contracts. Patches should be freely available at all times. Upgrades should provide new functionality with an optional price.

Gay Gordon-Byrne, TekTrakker

“In the last couple of years, things seem to have got worse.”

 That sentiment about the unfairness of risk allocation in contracts is one I have encountered many times during discussions in recent weeks. There is a feeling that large corporations and major public sector bodies have become more risk averse and have used current economic conditions to exert their strength – liabilities, indemnities, IP rights, termination provisions, performance criteria and (in the corporate sector) payment terms have been areas of focus. And despite their insistence on ‘the integrity of contract’, these same organizations think nothing of using their power to force unilateral renegotiation when conditions change.

 Overall, I think things have become worse. Ironically, on one hand economic conditions have forced many corporations to take added risk (new markets, more rapid product development, supplier consolidation are examples), but at the same time they have sought to clamp down further on their established suppliers, without much regard to the business consequences.

 Some legal and procurement staff stick to the belief that harsh terms drive performance. Short-term and for commodity acquisitions, that may be right. But for any more complicated or long-term acquisition, all the evidence points the other way – that unfairness undermines loyalty and commitment, leading to poorer outcomes and therefore added risk.

 However, while things may have become worse, I see growing light at the end of the tunnel. I have the impression that an increasing number of organizations are starting to question their approach. This is leading to a number who have renounced liquidated damages; some who are questioning how they can be more intelligent in protecting (and exploiting IP); others who are looking for shared approaches to governance through better change provisions, escalation procedures and added flexibility through mechanisms such as ‘hardship clauses’. I believe the door is opening for those suppliers who engage early and demonstrate their capabilities and commitment to deliver.

 Relationships that extend beyond a few transactions will always depend on trust and cooperation. Failure to establish and sustain these characteristics will always result in degraded performance and missed opportunities. This truth is dawning on a growing number of those responsible for contracts and they are influencing their management and colleagues to think differently – to distinguish between risk allocation and risk management.

Should suppliers be allowed to claim force majeure and if so, in what circumstances?

Whenever there is a major incident, this question re-surfaces. Over the years, the list of incidents that constitute force majeure has altered, but the basic principles remain unchanged. Today, however, there seems to be reducing tolerance for this blanket provision that excuses all performance. A refinery fire at a Shell facility in Singapore, the Brisbane floods and the Libyan revolution have been recent examples that created debate and contention.

In part, these questions are fuelled by the rise of globalization. Increased exposure to less stable or predictable markets has increased the potential for force majeure. But there are other factors. For example, the pressure for constantly lower prices has impacted the relative risk and quality of supply sources; many crops today are grown on previously marginal or inaccessible  land. It was marginal and inaccessible for a reason. Similarly, there has been consolidation of supply, resulting in limited ability to switch in times of crisis.

Those who disagree with force majeure mostly seem to be buyers. They argue that a good supplier should have back-up plans (even though they do not want to pay the price premium that such plans would involve). And they also tend to overlook the mutuality of force majeure – when invoked by a customer, it is reasonable; when invoked by a supplier, it is unreasonable.

Mature organizations have a sensible discussion about force majeure incidents and consider the actions that can be taken to avoid them, or to avoid their severity. For example, do I want to select a higher price supplier who has fall-back facilities and proven disaster recovery plans, or do I want to multi-source, or am I prepared to take a lower price and self-insure? Increasingly, there are also possibilities to insure against force majeure risk (for example, Zurich Insurance). But again, this involves a cost – and, ironically, the insurer then wants to determine whether the buyer is taking intelligent risk decisions.

Another area of growing interest is to replace some or all of the force majeure clause with a more general ‘hardship clause’, under which the parties commit to a renegotiation if and when there is a major change to supply conditions.

It seems to me that this is another area of contract where there is room for increased discussion and differentiation. It also demands a term that is sensitive to the nature and sources of risk and which party is willing to pay to cover them.

This article is taken from the Commitment Matters blog. For similar items, visit http://contract-matters.com/

Despite continuing economic uncertainty, or possibly because of it, interest and engagement in supplier relationship management (SRM) continues to increase. This is evident in the findings of State of Flux’s 2011 SRM survey – the third year running we have conducted in-depth global research of this kind.