The problems and pitfalls of open book contracts

While we are currently well beyond the era where open book contracts where considered the ‘holy grail’ of procurement, there are still many companies that actively work with suppliers on an open book basis as part of their sourcing process and cooperation model.

Therefore, there is still value to be gained by creating better insights into the complications and pitfalls that may arise when a company engages in open book contracts with its suppliers.  

What is an open book contract?

First, we have to briefly clarify what an open book contract is and what it does.

In an open book contract the buyer and supplier agree to (i) which costs are remunerable and to what extent and (ii) the margin the supplier can add to these costs. Buyer and supplier thus maintain an overview of the remunerable costs and its percentage contributions to the overall selling price (including profit margin) and aim to update this when the different cost elements are subject to change. Open book contracts are sometimes also referred to as ‘cost-plus’ contracts, as the supplier would be paid an agreed profit margin on top of its incurred costs.

Benefits of an open book

Having an open book cost breakdown from a supplier can be a great tool to gain a better and more profound ‘ex post’ understanding of the key cost drivers of a supplier’s product or service offering. It additionally opens up the possibility to analyze which cost drivers might be addressed and improved in order to achieve cost reductions.

Another ‘ex post’ aspect of why organizations like open book contracts is because it gives them a means of controlling a supplier’s cost structure, helping them to achieve and maintain what they perceive as a ‘fair’ price.

In addition, there is also an ‘ex ante’ benefit of open book costing in the sense that a cost breakdown at the time of the RfQ helps the buyer to assess whether a supplier has fully understood the specification.

Should we trust our suppliers to be honest?

As Game Theorists, we cannot but analyze whether buyers should believe the figures reported by suppliers in an open book cost breakdown. In other words: Do suppliers have an incentive to report their costs truthfully?

As honest as the individual (be it sales person or CEO) may be, experience and theory tell us that in general individuals respond to incentives and tend to use the leeway they are given, especially if their behavior cannot be observed. Hence, the unfortunate answer to that question is ‘No’, which is the direct result of companies generally looking for profit maximization, giving them an incentive to hide profit margins in open book breakdowns in order to protect their profit margins.

But should we blame the supplier for this? Probably not, since setting no incentives or even the wrong ones remains the buyer’s responsibility.

As a result of the profit maximization paradigm, the supplier will feel a need to report low profit margins in an open book contract. The supplier might fear renegotiation of its price if he reports the high margin he is making and thus will need to hide margin in some cost buckets in order to present a lower profit margin in the breakdown to come to the same overall price.

Additionally, the supplier also has another incentive to report a low profit margin as this allows him to effectively use the open book breakdown to his own benefit in a (re)negotiation with the buyer by simply claiming: “Look at the open book, I only make a small profit margin, I have no room to improve. Plus, my costs are going up (wages etc.).” This is then very difficult for the buyer to counter.

Open books also allow suppliers an anchoring opportunity. By asking for an open book prior to the negotiation we invite suppliers to set anchors from which it will be hard to negotiate them away.

Now that we have shown an incentive for suppliers to hide margin, the next question is:

How do suppliers hide margin?

We will identify the two main ways suppliers are able to hide margin and benefit from open books:

1.     ‘Reasonable bandwidths’: Costs are often verified within a ‘reasonable bandwidth’ (by cost engineers), this allows for suppliers to add 5-10% per cost driver as long as they stay within a ‘reasonable’ range. Doing this for all cost drivers allows suppliers to ‘squeeze out’ an additional 10% profit without red flags being raised. Cost Engineers use benchmark information, which relies on non-negotiated values, which are generally already significantly higher than the supplier’s negotiated rates for a cost driver. Suppliers oftentimes know what the white spots are for their customers when it comes to understanding the cost drivers, so they will report close or closer to reality on cost drivers where the customer has very good insights and data points and will hide more margin in the areas that are less visible to the buyer.

2.     Fixed costs made variable: If the fixed costs (overhead costs) are listed as a percentage in an open book contract, many buyers overlook that they need to convert this to a fixed sum, resulting in ‘margin leakage’.

Example: If a buyer buys 1M pieces of a certain product from the supplier at €1/piece based on an open book breakdown in which the fixed costs are listed as 15% (€0.15/pc), then his contribution to the supplier’s fixed costs is €150k. If the buyer now buys 30% more volume (1.3M pieces) the following year, he should take care not to maintain the 15% in the open book as fixed cost contribution, as he’s then ‘gifting’ the supplier an additional €45k (€195k new fixed cost contribution vs previous €150k) or 3.5% profit margin increase. Fixed costs by its nature should not increase as demand increases (exception for circumstances of investments to buildings under extreme growth), certainly not in a linear manner, and thus the fixed costs contribution in the open book contract should reduce to 11.5% (€150k / €1.3M revenue). Note that even if the supplier would argue he had to increase his fixed costs as staff got more expensive, the buyer could argue that a 5% salary increase should only result in a fixed costs contribution of €157.5k (which the buyer can argue should be funded from the profit coming from the profit growth as a result from sales growth..).

Being aware of these manners by which suppliers look to hide margin allows for a more even playing field, while we also want to advise you on:  

How to protect yourself against exploitation of open book contracts?

As Game Theorists, we first and foremost advise to rely on competition rather than your supplier’s honesty (having his incentives in mind). This does not mean that we are a pessimistic bunch of people not believing in values like honesty. But better safe than sorry, especially if setting the right incentives does not harm your relationship with the supplier.

Having competition allows for a ‘rule-based’ negotiation, which does not rely on open book breakdowns to come to a good market price, as the multilateral negotiation process drives suppliers to report their market price truthfully. More on this process can be found here and here.

Under these circumstances open books can certainly have their place and merit (e.g. checking technical capability), while some companies simply have a rule that requires buyers to have open books in place.

Let the record state that we do not advocate against deep and meaningful collaborations with suppliers. In fact, we strongly believe that close cooperation with suppliers can generate a lot of additional value to the value chain. 

We should however design our sourcing and contracting processes in such a manner that suppliers are incentivized to report their (commercial) data truthfully, which is not something an open book contract achieves on its own. Supplier relationships are not helped by tools and processes that incentivize suppliers to behave in an opposite manner.

Unfortunately, many buyers face a reality in which they do not have a competitive supply base (yet). So, if you cannot do without an open book for the one or the other (legitimate) reason, make sure that the rules within your open book contract are designed to set the right incentives, while keeping in mind the 3 simple rules we advise you to follow:

1.     When looking to check technical capabilities, make sure to ask for the breakdown early in the RfQ process and follow up with technical talks.

2.     If there is a company rule to have open book breakdowns in place with suppliers, then ask for the breakdown only from the winning supplier AFTER the negotiation. Consider that if you had asked the open book after an RfQ price of 100 and the supplier reported his breakdown with 10% profit. If the supplier now wins the rule-based negotiation process with a price of 85, he will have a hard time providing a credible open book breakdown without losing face.

3.     Do NOT agree to an open book when buying a ‘black box’ product or service. If you are not going to be in a position to verify the majority of the reported cost drivers, you will be much better off to negotiate a fixed price without agreeing to details. This will protect you from the supplier using the open book against you in a following negotiation cycle.

Next time you are considering an open book contract with a supplier we hope you will benefit from our recommendations and find the ways to navigate around the pitfalls. Good luck!