360° Vendor Management

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!

This entry was posted on Thursday, April 3rd, 2008 at 9:33 pm and is filed under Metrics, Outsourcing SLAs. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.