Outsourcing Contract Penalties: Do Vendors Respond to the Pain?
“It’s odd that you can get so anesthetized by your own pain or your own problem that you don’t quite fully share the hell of someone close to you.” — Lady Bird Johnson
If a pound of carrots doesn’t drive outsourcing vendor performance, maybe a little pain will? Read on to learn how to structure service level credits to incent vendor performance.
Many services, outsourcing, and vendor management programs are governed by service level metrics and key performance indicators. When the vendor fails to meet established standards, they are financially penalized. This is a form of liquidated damages.
With little doubt, penalties in small quantities, as well as the threat of greater financial impacts, drive vendor performance. While not every vendor will be enterprising enough to strive for incentives, no vendor likes to forgoe margin. However, nickel and diming a vendor wont get attention. A structured performance management program will squarely drive root cause analysis and performance improvement, but a significantly sized penalty catches the attention of vendor account management executives and CFOs.
It is important to establish this structure in your contract before or during negotiations, as seeking penalties without a contractual framework is next to impossible. This part of negotiations is significantly difficult to resolve because questions of fairness, profitability, and integrity are frequently discussed.
Without any doubt, vendors price risk into their contracts. No vendor expects to achieve 100% of all service levels on a regular basis, thus they pad their profit margins to accommodate some performance issues. The most sophisticated vendors run probability models to determine likely impacts to their profitability, and they price this into their model. This is why vendors frequently ask clients for historic performance over the last 6-24 months. It helps them understand how much they must pad their margins (in addition to understanding the severity of the measurements or the desperation of the client to find a higher performing solution). Sharing this information can be hurtful and helpful – use judgment when considering the release of performance data.
Service level penalty/credit structures typically have the following key characteristics:
- Capped Risk – Unlimited risk is difficult for anyone to handle, so vendors will principally focus on capping the maximum payout for poor performance. The numbers range from 2% to 200% of weekly, monthly, quarterly, or annual invoice amounts. While it’s fair to exempt certain fees from being included in the invoice amounts (for example, travel expenses), almost everything else should be included as the fees are all supposedly tied to the performance of the vendor.
- Weighted Metrics – Undoubtedly, clients have a certain number of metrics they want measured. Since they have different values to the client, the client weights the metrics differently. This can be done by allocating a fixed number of points across the metrics or simply identifying different penalty amounts for each metric which reflects the metric’s importance. Clients who have too many metrics will find the penalties to be too small. A good number is between two and six. Remember to avoid “double jeopardy” situations where failure to achieve one metric causes other metrics to not be met (except in catastrophic situations).
- Accelerators for Significantly Poor Performance – In a black and white world, performance either meets or fails to meet expectations. However, a vendor who misses the goal by .01% versus 75% should be impacted differently. In addition, a vendor who consistently misses the same goal, should feel the pain level ratchet-up. Vendors will often offer termination for breach, but most companies aren’t going to terminate, as the switching costs are too high. As a result, clients need to include mechanisms that multiply the penalties until the problem is resolved.
- Excused Non-Performance – The vendor isn’t always at fault for failure to meet expectations. Either figure a way to carve the work impacted by a company or uncontrollable event out of the calculation or allow the vendor to be excused from a portion or the entire metric.
- Date When Penalties Go into Effect – Establish an effective date for each metric to ensure the vendor knows when the penalties will go into effect. Potentially ratchet them up to full strength over a period of time to ensure smooth implementations. Remember, a classic move by a vendor in the middle of implementation/transition is to ask for a delay in this effective date to accommodate learning curves. Generally, do not provide forgiveness, but a good alternative if the reason for the delay is not solely the vendor’s problem is to offer an earn back if the vendor achieves the performance metric one or two months late.
- A Framework for Change – As operations often change, as do their leaders, its important that clients reserve the right to change metrics as needed. Vendors would love to force this through change control, as it gives them a second opportunity to negotiate down the penalties. Good contracts allow clients flexibility to add and delete metrics, as well as change their relative weighting.
Lastly, one of the most important issues clients need to realize is that there have been many, many bad clients who swindle vendors into agreeing to performance metrics that the vendors could never reasonable achieve. These unscrupulous clients use service credits to receive discounts on the services. This is not fair and you should never permit this to occur – it destroys the foundation of a good client-vendor relationship.
Do you use other other methods of managing service level penalties or credits? Leave a comment!
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An additional approach is to add incentives for supperior performance, especially for those metrics which measure cost, just make sure there is a cap so the vendor is not incented to a point of driving on metric at the cost of others.
Just wanted to find out whether there is any framework or methodology that can be used to validate performance metrics.
@ Peter: What do you mean by “validating” performance metrics?
It is a nice blog! very interesting topic. I want to ask if this is a big disadvantage?Thanks!
Capped risk is an interesting idea, not sure how you control excused non performance. While it’s not a perfect world, where do you draw the line when it comes to lapses in it outsourcing quality control??
Over time I’ve found that vendors are more responsive to fee incentives/rewards than outright penalties. But I often use some combination of both for my clients. A fee incentive for producing a key set of deliverables with quality, on time and within budget, and then penalties if the key set of deliverables is not produced on time, etc.
The danger with penalties is that they cannot be overly punitive. If a vendor finds itself in penalty land, and its working to finish a project at a greatly reduced rate, you could find the vendor’s B Team showing up to complete the project, then the C Team, and so on. Most project owners want a finished project, not a languishing project.
I’ve also found that if the vendor ends up in penalty land, they will defer the project behind actual paying clients.
Kendall Gordan, SE
http://www.foxfiresoftware.com
You could find the vendor’s B Team showing up to complete the project, then the C Team, and so on. Most project owners want a finished project, not a languishing project.
What I have found to be more useful than financial penalties, yet has a financial impact is requiring doubling up on resources to solve the problem. For example, if QA is not up to par for a second consecutive month, then instead of requiring the vendor to continue to perform QA in the same manner, require additional monitoring to occur. So if 5 monitoring per month per agent is standard, then require 10 per month per agent. This should drive quality more than a financial penalty and yet to accomplish the 10 monitoring per agent per month, it will also require the additional quality resources to complete which is also a financial impact. Quality should be improved unless there is a serious process issue that no matter how many monitorings and coachings are completed, it wont solve the problem.
Good article. my comment on the underline question is that – vendor financial penalties cause lot of pain to outsourcer if this is not well supported by strong governance and executive buy-in.
There are many areas where vendor performance is expected to meet SLAs. In today’s outsourcing environment and considering the business sensitivity of outsourced work. It is important to see vendor perform and stay a step in front to any of customer’s security compliance requirements. Concept of vendor penalties in risk and security requirement adherence area, supported by strong governance and reporting mechanism is extremely effective and useful.
Don’t forget the processes and people you have to put in place to monitor the oursourcing firm. They have become very good at hiding behind abstract reporting, conflicting statistics, etc. It becomes a lot of work to “proove” SLA’s are made or missed. You cannot count on reporting alone…
At the risk of diverging from the original point, but in answer to CC’s post, reporting on its own can, in a mature engagement, be relied on. As the engagement matures, the customer should be moving away from control (detailed data analysis at the contract, service and engagement layers) to a level of trust (automated, trusted reporting data) To hold onto a large degree of control for an indefinite period can be detrimental to the relationship. In the extreme it can result in a perceived problem turning from just that to an unrecoverable one and termination being served without the vendor actually understanding why. The customer is then back where they started and applying control over the new vendor and eventually know no different.
As for penalties, I dont believe they work, since the vendor has usually factored them into their costs and expects them. Only if the vendor is greedy and wants to keep the fat, will penalties have an effect……..and do you really want to work with a greedy vendor. Far better is to lock the vendor into your success. Offer bonuses aligned to areas of your business that the vendor can have an influence upon. Not easy, I admit, but much more beneficial to both sides.
Question – are contract penalties actually enforceable in the US?
From what I’ve been able to find – US contract law does not provide for contract penalties or punitive damages. Thus, liquidated damage provisions are enforceable only when they compensate a party for damages that are difficult to quantify and reflect a reasonable estimate of expected damages calculated at the time the parties enter into the contract. They must also be exclusive in that they are a substitute for any actual damages that may be incurred.
This is a very good blog and touches on lots of the key points I have heard both service providers and clients talk about. I think the truth is that performance management is really still in its infancy in outsourcing. Whilst clients invest lots of time and effort creating KPIs they are rarely managed effectively. A lot of this is related to the focus that tends to be put on ‘issues’ rather than service quality. Many operational people on the client side can feel they are too busy dealing with issues to manage at the serivce level. When KPIs need to be managed with spreadsheets and e-mails then this is an understandable sentiment. We have taken on the task of trying to simplify the whole performance management process through our product but are extremely conscious that what’s needed are simple flexible solutions. I do not agree for a minute that clients should ever lose control of the detailed service data – trust with information is just stupid blind faith = and despite what service providers might like to say it is always a commerical client/vendor relationship.