Including Incentives in an Outsourcing Contract | Article

Outsourcing Suppliers earn moneyProviding incentives to encourage the behavior your want is a powerful way to moderate behavior. Parents use it to push for good grades. Puppy owners use it to train Rover to fetch. Now outsourcing customers are writing incentives into their contracts to improve the performance of their suppliers.

Incentives are helpful when structuring an outsourcing relationship, observes Robert Zahler, a partner at Shaw Pittman, a Washington, D.C. law firm specializing in representing clients who are the customers in outsourcing contracts. Carefully structuring the incentives help “both parties perform as they promised in the negotiations,” he says. The difficulty, however, is to devise an incentive program that is fair as well as produces efficient performance.

Currently, Zahler says, there are three outsourcing models that companies can use when negotiating outsourcing contracts. Using the help desk function as an example, the first model would have the supplier agree to employ 15 people who answer as many questions as possible as quickly as possible. The customer can chose to add more people if the workload increases, but it does so at its own expense. Of course, if it subtracts the number of staffers, its cost goes down.

Zahler says neither the customer nor the buyer like this alternative. The customer can become unhappy because there’s no economic driver for the supplier to be more efficient. The supplier doesn’t like this arrangement, either, because there’s no way to use leverage or economies of scale it brings to the equation to increase its profits.

Charging By the Call

The second option is for the supplier to charge the customer by the call. In this model the volume determines the customer’s bill. Vendors like this method because they can allocate their staffs by studying the history of the number of calls.

But customers don’t like this approach because there is no economic incentive to push the suppliers to become more efficient. They don’t have to train their staffs in better techniques. And they don’t have to invest in new hardware or software to automate and upgrade the process.

The third option uses the incentive method. The buyer pays the supplier by the user. If the customer adds more people, it pays more money to the supplier. Customers like this approach because they only pay for what they need. The economics of the deal force the supplier to perform in the most cost effective way. “If the supplier can be efficient, it will earn a windfall. But if it’s inefficient, that will cost the organization,” says Zahler.

Vendors, however, are not always comfortable with the incentive model. They know that the customer’s employees can call all the time. And they know the number of calls will go up whenever they roll out a new program.

Bringing In New Technology

Expect more difficult contract negotiations if you are going to include penalties and bonuses in its outsourcing contract, points out Zahler. Determining accurate and accountable service levels becomes trickier. The customers want to keep the service levels high so they don’t have to pay a bonus. Vendors naturally want them as low as possible so they won’t be subject to the penalties. “Incentives add another dynamic to the negotiations,” says Zahler.

One of the reasons customers chose to outsource is to let the vendor keep up with the latest in the field. Customers expect suppliers to bring new technology and ideas to the outsourcing relationship. When they are in a selling mode, vendors are willing to do this, Zahler observes. However, things change once they sign a contract. “In reality, most customers never see new technology,” says Zahler.

Zahler says customers should find ways using incentives to encourage the vendor to keep them on the cutting edge of technological change. One way is gain sharing. If the vendor brings a new skill set to the relationship, which leads to increased productivity or reduced costs, then both sides agree to share the gains financially.

The recent procurement contract ANZ Bank in Australia signed with PricewaterhouseCoopers (PwC) is a good example. ANZ Bank pays PwC a base fee. Then, the outsourcing provider receives an increasing percentage of the cost savings it can produce.

Sharing The Savings

Of course, both sides can disagree on how to do this. Vendors would like to get their savings in the first tranche or segment. For example, they want to share equally with the buyer the first 25 percent of the savings produced. Buyers, of course, want to invert that. The natural yin and yang should produce a healthy outsourcing relationship.

Lessons from the Outsourcing Primer:

  • Outsourcing contracts can be structured three ways: per head, per call, or per seat (user).
  • Incentives add another dynamic to the contract negotiations.
  • Customers should set penalties high enough so it’s cheaper for the supplier to do the job in the first place.
  • Gain sharing allows both parties to benefit financially when the vendor introduces a new technology or skill set.

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