Outsourcing Contract Incentives: What is a Pound of Carrots Worth?

Posted by tony on Tuesday, April 1, 2008 · 8 Comments

Do you wonder if contractual performance incentives work? These are the “bonuses” vendors get for exceeding service level agreement (SLA) performance targets or achieving certain milestones earlier than expected.

We do, too. Take the poll survey, view the results, and read our nine suggestions on how to make the best use of contract incentives.

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There is a tremendous amount of academic and business research on economic incentives. Most of the academic research pertains to controlled environments too dissimilar to normal business situations to be applicable. The business research is non-conclusive and the authors lack sufficient objectivity. Therefore, you’re treading into generally foreign waters.

When you are considering incentives, keep a few concepts in mind:

Don’t offer incentives for “showing up”. Incentives should be offered for significant performance achievements. If the vendor has offered to do xyz, actually doing xyz shouldn’t earn an incentive. In fact, failure to do xyz should result in a penalty.
Understand the economics of the metrics. Incentives frequently do not make sense to offer. For example, a call center frequently tracks abandonment rates. Reducing abandonment rates frequently requires different workforce management ratios. The cost of these ratios frequently exceed the value of the incentive – so the vendor isn’t driven to achieve this incentive.
Use clear language. Just as with any metric, KPI, or transformational goal (we’ve authored articles on all three areas), clearly define the threshold and payment calculations. Check out the “$1 Million Comma” for an example of poor contract drafting.
Cap your exposure. Never, ever offer unlimited or undefined maximum payments to vendors. If there are multiple incentives, cap the aggregate at risk amount you have.
Use graduated incentives. Don’t offer a 5% incentive for exceeding normal performance by .01%. Offer gradually greater incentives for gradually better performance.
Consider penalty/credit earnbacks as an alternative to incentives. For example, consider a weighted yearly average of monthly performance metrics and be willing to credit a certain percentage of those credits if yearly performance exceeds certain targets.
Don’t offer incentives that drive perverse behaviors. Providing an incentive to a vendor to achieve a certain productivity goal may result in lower quality results. Consider using double barreled incentives to eliminate this from occurring.
Consider the magnitude of incentives. If a vendor expects a regular 10% profit margin on services and the cost of achieving an incentive is negligible, but it provides a 5% bonus on gross revenue, you’ve increased profit margins by 50%!
Track incentive payments. Use this information to understand the true cost of performance and to negotiate lower rates for same performance at contract renewal points.

If you have additional thoughts, share it with the ever growing readership of 360° Vendor Management by leaving a comment.

Filed under Contracting and Negotiating, Featured, Vendor Management Fundamentals · Tagged with incentives, Metrics, Outsourcing, service levels, SLA, Vendor Management

Comments

8 Responses to “Outsourcing Contract Incentives: What is a Pound of Carrots Worth?”

Jeff says:

April 2, 2008 at 3:05 am

I haven’t yet written about this over at the licensinghandbook.com site… but I’m 100% opposed to incentives that are anything less than penalties. The simple way to say it is that I don’t feel that I should pay EXTRA to get the vendor to do what they’re supposed to do anyways.

Now, in #5 above, you start to go down a path that I might be able to swallow: where you’d pay an incentive to get BETTER performance. But if you’ve got something like a requirements contract going on already (ie: we need at least x widgets each month; or we need x availability each day), I am not convinced that I would want to promise to pay more.

In other words, if I need 90% performance, I will pay for 90% performance – not 89% and not 91%. If I want to pay for 90% performance and really would like 95% performance, but think that the last 5% is going to be REALLY hard to do, I want to simply make it a contingency and I’ll phrase it as a contingency.

OK… I think I have a new topic to write about. Thanks Tony!
tony says:

April 2, 2008 at 5:47 am

I knew this topic was going to get under the skin of some people! I’m not sure incentives really work because I’m not sure vendors’ staff are incentivized in a way to drive motivation. The results are typically driven by middle level operators who aren’t measured on profit and loss. Personally, I think many clients make incentives too easy to achieve and incentives become a back door for vendors to grab back at margin they lost in negotiations.

It is possible to make incentives that work, but they have to be focused on quality and be carefully considered. For example, I think it’s a renewal discussion point or a change order discussion point in which a client desires higher levels of performance and offers the first 6 months of incentives to achieve the goal. After 6 months, the stretch goal becomes the only goal and failure to achieve it results in credits…
Eliz says:

July 7, 2008 at 9:01 am

I agree that it is difficult to swallow paying an incentive for behavior and perfomrance a vendor should be supply anyway. However I am struggling with how do I get the vendor to be more proactive in process improvements, automation of mundane tasks, strategic thought process? What contractual language can I put in place to ensure the outcome of the above? I shouldn’t have to pay “extra” for these things
Esteban Herrera says:

August 21, 2008 at 3:17 pm

There are some not so subtle differences here. I have had a few incentives that work, and a large majority that are ignored by both parties. Two simple thoughts:

1. Of course you should not pay extra for expected performance
2. You should only pay extra for performance above and beyond “expected” if it makes a meaningful difference in business performance. For example, I am not sure my business makes any money by keeping a box “up” for an additional 30 minutes. But I am absolutely sure that if a call center agent upsells customers beyond my expectations, I am making more money and its fair to share some of that with the vendor that is making it happen.

Point #8, by the way, is one of the most important and most often ignored throughout the courtship and negotiation process–and its importance goes far beyond the penalties and incentives discussion. If you don’t understand to a very fine level of detail how your provider makes money, you have no business doing that deal.
Kendall Gordan, SE says:

December 1, 2008 at 12:57 pm

All incentives should be verifiable as well as a proven ROI prior to payouts…As my management says, we ARE already paying you for a days work in a days time!

Kendall Gordan, SE