Prime Vendor or Fixed Margin Agreements: Are They Really What You Think?

By James R. Covart

If you discovered that one of your employees was receiving a monetary allowance or incentive for purchases made by your restaurant and without your knowledge, what would you think?  You would probably be concerned and want to learn more about it.

If you have a prime vendor or fixed margin arrangement with a large broad line supplier, something similar to this may be taking place without your knowledge.  No, it’s not your chef or manager who is receiving these allowances, it’s your supplier.  It has been going on for several years now and the practice is growing in the industry.  Distributors use sanitized terms like “program money” and “sheltered income” for the practice and seldom discuss this income stream with their "end user partners" or their sales associates.

“Not us,” you say, “We have a great relationship with our supplier.  We are partners.”

You have negotiated a prime vendor arrangement with one of the country’s largest broad line distributors.  The agreement provides that your prices be based on the supplier's “invoice cost” plus a fixed margin, plus the cost of freight from the producer to your distributor’s warehouse.  The agreement even permits you to audit their invoices.  It’s an airtight deal; no hanky-panky here, right?  Not necessarily.

Here’s one scenario:

Your distributor, Large Broadline Distributor, LBD for short, sells you Major Brand French fries.  You have done taste and quality comparisons and believe that the Major Brand fries are right for your guests.  You have served Major Brand French fries in your restaurant for several years now and are very pleased with the product.  Major Brand is not the least expensive fry available, but it’s what you choose to serve in your operation.

One day, your LBD representative tells you that the price for Major Brand French fries has increased.  He tells you that you can save some money by switching to LBD's own house brand of French fries.  The LBD Brand French fries are packed by Major Brands and he assures you that they are "the same" as those packed under the Major Brand label.

LBD’s "invoice cost" from Major Brands for LBD Brand French fries is $12 per case.  To that LBD adds the agreed upon margin,10%, and an inbound freight cost of $4 per case.  Your price for the LBD Brand French fries is $17.20 per case.

“OK,” you say, “sounds like a good deal, but prove it to me.  I want to see the invoice.”  No problem; LBD shows you an invoice from Major Brands that clearly shows a $12 per case cost and a freight charge of $4 per case.  “Very straight forward and honest,” you say and agree to buy LBD Brand fries.

At the beginning of the next crop year, LBD asks Major Brands for a price to pack the LBD Brand French fries for the upcoming year.  LBD also requests a price quote from Minor Brands and Super Brands, the other two major packers of French fries.

This year, Minor Brands is very aggressive.  They want LBD’s business and offer to pack LBD Brand French fries for $10 per case, $2 per case less than Major Brand’s offer.  The quality of the product is not quite as good as Major Brands, but LBD likes the price and believes that most of their customers will not notice the slightly shorter length,  reduced yield or texture difference between the Major Brands and Minor Brands products.

The sharp LBD buyer proposes an alternative billing arrangement to Minor Brands.  “Invoice LBD for $12 per case. Then rebate us an allowance of $1 per case at the end of each month.  By the way, did I mention that LBD has a product show coming up and we require each of our suppliers to chip in to cover the cost of the show?  Did we talk about the warehouse slotting fees?  Don't forget that you will need to pay us a fee to show your product to our sales associates at our next sales meeting or the contribution towards the trip promotion that we run for them.”

The deal is struck.  Minor Brands will invoice LBD $12.00 per case for LBD Brand French fries..  This is the invoice LBD will show you if you are on a prime vendor or fixed margin agreement with audit privileges.  LBD will receive a monthly check from Minor Brands for a $1. per case allowance and for an additional $1 per case to cover the “bill backs” for the product show, slotting fees and promotions etc.   Minor Brands has no problem with this arrangement.  After mailing LBD their monthly checks, Minor Brands still winds up with a net income of $10 per case for their fries, just what they asked for in the beginning.

On your next order, you receive LBD Brand French fries.  The case looks the same as it has. in the past.  However, the French fries are now packed my Minor Brands instead of Major Brands.  No one form LBD tells you they have switched packers.

Your sales person knows nothing about the $2 per case in “sheltered income” that LBD is receiving from Minor Brands.  Your price continues to be $17.20 per case, calculated on the $12 per case “invoice cost” plus the $4 in freight. The LBD sales person continues to be paid a commission based on a percentage of the difference between LBD’s “invoice cost” of $16 per case and the $17.20 price that you pay.  If he sells enough of the LBD Brand fries, he might even win a trip!

Here is the bottom line:

• Your distributor has changed the product without telling you.
• You continue to pay $17.20 per case for LBD Brand French fries.
• You are now receiving and serving a lesser quality product with a lower yield. You may not even be aware the product has changed until you receive complaints or notice that your food cost has gone up.
• LBD puts the $1 per case rebate and the $1 per case in bill backs in the bank and lists it as sheltered income on their annual report.

Here are some things that you can do to insure that your operation gets the products that you choose at the best price

• Develop good product specifications.  If brand is important to you put the brand in your     specification.  If brand is not critical but quality is, specify a standard such as “USDA Grade A Extra Long Fancy.”  If you use a “house brand” on an important item, be sure you know who packs it for the seller.

• Be skeptical when a sales representative tells you “it’s the same thing.” If your distributor discontinues stocking a particular brand but says that the same manufacturer packs their house brand, insist on a side by side comparison.  Often, the quality of the house brand will be lower than the packer’s name brand.  You should repeat the same side by side comparison periodically to make sure that the distributor’s house brand continues to match the name brand.

• Request that you approve any product substitutions in advance.  Do not have distributors automatically substitute products that you have not tried and approved.

• Get to know manufacturer and packer representatives and brokers.  They are a valuable source of information.  If you want to meet with a broker, make the appointment directly and not through your distributor.  If an appointment is made through a distributor, the broker may feel obligated to show you only the products that the distributor wants them to and may neglect to show you other worthwhile products that are available through other suppliers.

• If your supplier is a publicly traded corporation, request a copy of their annual report.  This will help you to better understand their cost and profit structure.

• Shop around.  Even if you trust your suppliers, frequently spot check pricing with other vendors.

• The “cost” in cost-plus contracts can be difficult to pin down.  If you have a cost-plus arrangement with a supplier, always ask how “cost” is calculated and how they handle “program money.”

• Understand that a supplier can increase their income (and your cost) by manipulating “cost” and “program money” amounts and still appear to be maintaining the locked in margin percentage that they have agreed to with you.

• Ask how shipping costs are calculated if this is part of your agreement.  Is your supplier charging you a fair market rate?  Your suppliers may pickup products with their own trucks and then pass along inflated shipping charges to their “cost-plus” customers. 

• Don’t be blinded by percentages and margins.  Keep in mind that the only important number is the amount that you actually pay for a product.  

• Make sure that if a supplier wants to build a “partnership” with you, that it is a two way street.

In the end, I like to remind my clients that if a supplier cheats you, shame on him, if he does it a second time, shame on you!

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