Sourcing Inside Out: Penalties and Incentives in Outsourcing Contracts

Punish bad behavior and reward good behavior. It’s a time-honored approach to motivation. Define basic expectations, and make it clear that consequences await if those expectations aren’t met. At the same time, encourage excellence and achievement through financial and other incentives.

These principles can play a central role in managing an outsourcing relationship. By effectively defining penalties and incentives tied to specific business objectives, clients can create powerful incentives to work towards mutually beneficial goals.

The Basics of Penalties in Contracts

Let’s start with penalties. The basic goal should not be to punish, or to find ways to pay less for poor service, but rather to prevent problems from occurring in the first place. If a slip does occur, the penalty should produce a change in behavior that not only fixes the problem, but also ensures it isn’t repeated in the future.

Penalties should be sufficiently substantial (read: painful) to prevent complacency and sloppy work. And the pain should get worse: Penalties for repeat transgressions should escalate and increase with each repeat occurrence, up to a specified maximum. This is essential to motivate vendors to focus attention on problems early and fix them. Penalties should be paid in the month after the failures occurred – and not tallied for reconciliation at year end. Otherwise, the direct connection between poor performance and the penalty is lost, as is the sense of urgency to take corrective action.

It’s generally a good idea to define penalties so that they reflect the relative importance of the services involved; in other words, the more critical the service, the tougher the penalty if that service suffers. Penalties can also be tied to trends, so that a downward trend over several months gets penalized, rather than any one particular anomaly. Vendor staff turnover can trigger penalties if staff continuity is a priority; this can discourage service providers from reassigning staff to other clients.

It’s important to focus on how penalties are defined in the contract to ensure that loopholes are closed. Vendors can use their negotiating prowess to “mitigate risk” and agree only to penalties that are a slap on the wrist. For example, contracts can be written so that a minor penalty results for every single missed performance target. While the language creates the impression that the vendor is buttoned up and detail oriented, this approach of spreading penalties out over too many targets simply waters down the ability to have any impact on top priorities. The result is that any single miss results in only a minor annoyance for the vendor, who has little incentive to change behavior and strive for quality.

Effective penalties motivate vendors by making them focus their efforts on what’s really important to the business. Each miss in critical service areas should produce a deeply felt impact. Put differently, given a penalty “budget” of 15 percent of the contract price, knowing where to “invest” that 15 percent is the magic formula. A vendor who faces a 10 percent penalty for missing a service level target will direct considerable energy and enthusiasm to ensuring that target is never missed. And don’t worry about setting stretch targets – studies demonstrate that challenging service levels are more frequently attained than easy ones.

Avoid Averages in Contracts

Be especially wary of vendor proposals to “average” service level performance over time. Meeting an average over the month is quite different from meeting the service level consistently each day. Overachievement generally has no value to the client, but it can offset underachievement – which does impact the client – and allows service levels to be met “on average.”

Penalties tied to outages must be explicitly defined and scaled to deliver bigger hits for longer outages. For example, if acceptable outages are set at a maximum 30 minutes per month, you must specify that the penalty for 400 minutes is greater than for 31 minutes – if not, the penalties may well be identical.

Also consider the difference in impact between one 30-minute outage and 30 one-minute outages. A sliding scale of penalties can be an effective tool for managing application availability. Penalties can be tied to number of users impacted, number of sites impacted, number of applications out at one time, duration of the outage (e.g., up to two hours, two to four hours, more than four hours), first or second time this month, or this quarter, and so forth.

As a final recourse, contracts should include language stipulating that repeated failure to meet service targets can permit the client organization to terminate the contract for material breach. Contracts should be clearly worded to specify what exactly constitutes “material breach.” Lack of service level attainment can be scaled to define at which point material breach has occurred. For example, missing key service level targets for three consecutive months might be considered material breach in some contracts.

Incentives: A Bit Trickier in Contracts

Now, let’s talk about incentives, which are in many respects a bit more tricky. Done right, incentives can enhance motivation and accountability (and thus results), and foster healthy competition, particularly in a multi-vendor environment. As with penalties, it’s essential that the specifics of any formal incentive program be clearly spelled out and tied to business objectives, and documented and communicated to all who can potentially contribute and benefit.

Generally speaking, vendors should be rewarded for identifying cost saving opportunities, implementing initiatives that contribute to business success, or improving services that contribute to business success. Avoid incentives tied only to the attainment of service levels – after all, why should you pay a bonus for services you’re already paying to receive?

Achievement bonuses are typically one-time payments for reaching certain milestones. These may be tied to earlier-than-expected completion dates, higher-than-committed critical service levels (only if this overachievement adds additional value to the client), or better-than-expected throughput.

Incentive programs can include individual incentives for both vendor and client personnel; annual payments to individuals who have made a significant contribution, based on nominations from peers, management from both sides, or other agreed upon criteria.

It’s often a good idea is to define incentives so that attainment of a goal results in a bonus for both client and vendor personnel, so that both sides are motivated to work together.

Powerful Tools

Penalties and incentives are powerful tools that, used wisely, can build effective, successful, and innovative outsourcing deals. Consistency is key. Unenforced penalties lose their value, erode management credibility, and can undermine the entire relationship. And incentives must be honored when goals are achieved. Unrewarded effort is unlikely to be repeated, and unmet promises may foster resentment and a decline in future performance – which is worse than offering nothing at all.

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