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How to write a Vested Outsourcing contract

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In this excerpt from the book Vested Outsourcing: Five Rules That Will Transform Outsourcing, the authors explain how to write contracts that allow an outsourcing partner to profit in exchange for achieving the desired performance outcome.

Vested outsourcing is a new methodology that allows companies that outsource certain activities and their service providers to work together more effectively. Under this approach, they work collaboratively to develop a performance-based partnership in which both parties' interests are aligned, and they become vested in each other's success.

One of the difficulties involved in choosing the right pricing model for a Vested Outsourcing agreement— one that provides incentives for the best cost and service trade-offs—is that there is often confusion about the different models used to construct the agreement. This confusion is due to the lack of consistency in how terms are applied to specific contract elements.

Article Figures
[Figure 1] Comparison of contract types
[Figure 1] Comparison of contract types Enlarge this image
[Figure 2] Pricing model selection guidance
[Figure 2] Pricing model selection guidance Enlarge this image
[Figure 3] Benefits and drawbacks of incentives
[Figure 3] Benefits and drawbacks of incentives Enlarge this image
[Figure 4] Types of incentives
[Figure 4] Types of incentives Enlarge this image

In this excerpt from our book, we clear the fog around pricing models by providing a basic vocabulary and set of definitions that companies can use to determine which pricing model and incentive types are best for them. In addition, we provide a framework for helping organizations understand the key attributes of pricing models and determine which model to apply to which type of contract.

Basic principles of pricing models
It is important to keep in mind two principles when selecting a pricing model:

  1. The pricing model must balance risk and reward for both organizations. The agreement should be structured to ensure that the provider of the outsourced services (which we generally refer to as "the outsource provider") assumes risk only for decisions that are truly under its control.
  2. The agreement should put pressure on service providers to provide solutions, not just activities. A properly constructed Vested Outsourcing agreement encourages the service provider to solve the customer's problem. The better the service provider is at solving the company's problem, the more incentives, or profits, it can earn. This fact encourages outsource providers to develop and institute innovative and cost-effective methods of performing work in order to drive down total cost while maintaining or improving service.

It is also important that Vested Outsourcing teams structure their agreements around reducing the total cost of the process that is being outsourced, not just the costs of the transactions performed by the outsource provider. Outsourcing relationships have interwoven dependencies that require the service provider to work (and push the company that is outsourcing) to change internal processes if they are inhibiting the success of the venture. In other words, the outsource provider is a profit maximizer.

Companies often struggle to select the proper pricing model that will best support their business and still provide the appropriate incentives for the service provider. As we will explain, the pricing model should be based on the appropriate type of contract and the incentives used to reward the outsource provider. In addition, the length of the contract and the prospects for stable demand and funding play an important role in selecting the pricing model. The outsource provider will use all four of these factors to calculate the price for its services.

Selecting the right type of contract
As mentioned, most companies rely on one of two contract types when building a pricing model for their outsourced business arrangements: fixed-price and cost-reimbursement. In both cases, a company is expected to pay the outsource provider for its costs and a profit for performing its services. A high-level comparison of these contract types is shown in Figure 1.

Cost-reimbursement contracts
Under a cost-reimbursement contract, a company pays its outsource provider the actual costs to perform a service. By definition, a cost-reimbursement contract is a variable price contract, with fees dependent on the amount of service provided over a specified time period. This type of contract is appropriate when it is too difficult to estimate a fixed price with sufficient accuracy and/or when the outsource provider will not agree to bear the risks associated with unknowns. Cost-reimbursement contracts often are used for the development of a new product or service, because the work cannot be clearly specified, or when outside forces (such as weather) will dictate how frequently the service will be provided (for example, snow removal).

In addition to paying for actual costs incurred by the outsource provider, the company pays the provider a profit. The profit is paid in one of three ways:

  1. A fixed profit fee (often referred to as a management fee)
  2. A variable profit, often a fixed-percentage markup that is directly linked to the costs (for example, cost plus 10 percent)
  3. A variable profit tied to prearranged targets, where the outsource provider is paid incentive fees for achieving desired cost or performance targets

Cost-reimbursement contracts often are referred to as "cost-plus" contracts, because the company reimburses the outsource provider for its costs plus pays it a profit. Some cost-reimbursement contracts estimate the total cost for budgeting purposes and to help the company set aside funds to pay the outsource provider.

One of the primary disadvantages of a cost-reimbursement contract is that the outsource provider has no real incentive to control its costs. If the fee is calculated as a percentage of the provider's costs, then as costs increase, the fee increases, too. The problem is that in this type of arrangement, outsource providers are not inherently motivated to reduce costs for their clients. If the provider manages to reduce costs, it is effectively penalized by reduced revenue and profits.

To address this issue, some companies are incorporating cost-based incentives into their pricing models. In these cases, outsource providers are rewarded with a gain share in return for reducing costs. The company that is outsourcing and the outsource provider share those savings. (It is important to keep in mind that although gain sharing does play a role in Vested Outsourcing, it is just one aspect of this methodology.)

Fixed-price contracts
In a fixed-price contract, the outsource provider's price is agreed in advance and is not subject to any adjustments. As such, the price the customer pays is fixed and includes the provider's costs and profit. A fixed-price contract therefore eliminates budgeting variation for the company that is outsourcing. Fixedprice contracts also are the easiest type of contracts to administer because there is no need for the company to keep track of actual costs to determine payment.

This type of contract places the maximum amount of risk and full responsibility for costs on the outsource provider. Its ability to manage costs directly impacts its ability to make a profit. The better the outsource provider controls costs, the more profit it can make. Thus, a fixed-price contract provides an inherent incentive for outsource providers to control costs and to put in place process efficiencies that drive costs down.

The company is at a significant disadvantage, however, if the actual cost of providing the services turns out to be less than expected. In this case, the outsource provider wins because it realizes increased profit margins without having passed some of the savings on to its customer, and the customer loses because it was not able to realize any of the outsource provider's cost savings during the duration of the contract. The opposite is also true, of course: if the actual cost of providing the services is higher than anticipated, the outsource provider loses and the customer wins.

This second scenario seldom plays out that way because the outsource provider typically seeks to renegotiate the pricing when costs are higher than expected. If renegotiating does not work, the outsource provider has two choices: subsidize the customer's operations, or cut costs by reducing service levels in ways not easily detected by the customer. Even if the cost of providing the services is not higher than expected, an outsource provider that focuses only on the short term may reduce service levels to increase the profitability of the account.1

As we have seen, both of these contract types have drawbacks. A fixed-price agreement may influence the outsource provider to cut corners, delivering services at minimally acceptable levels. A cost-reimbursement agreement may encourage the outsource provider to overspend, providing more services than really are needed. Under both pricing models, potentially perverse incentives may result in companies committing an excessive amount of resources to contract management; these perverse incentives must therefore be avoided.

When to use which contract type
We often are asked, "Which pricing model is better?" There is no single right answer. In our work, we have seen companies succeed with each solution. The parties must work together to determine which type of contract will best help them to avoid outsourcing mistakes and get to the "Pony." The Pony is the difference between the value of the current solution and the potential optimized solution. It represents something the outsourcing company wants, but was not able to get on its own or with its existing service providers.

Although there is no standard answer regarding when to apply which pricing model, there are some general guidelines you can follow. Figure 2 shows some of the different criteria that influence which pricing model a company chooses.

In addition to considering the criteria shown in Figure 2, it's important to base the selection of the type of contract to some extent on the outsourcing program's maturity level. For example, a well-established outsourcing program with a solid baseline and good data might be ideal for a firm, fixed-price contract. In the early stages of Vested Outsourcing efforts, a new program that is just starting and does not yet have accurate performance or cost data probably is most suited for a cost-plus contract. Later contracts can adjust for changes in maturity levels.

It is easy to see why we do not say that one method is best in all situations. The different criteria in each relationship will lend themselves to one model or another.

The role of risk in pricing
Risk is one of the more important criteria in selecting the appropriate pricing model. It plays an important role in deciding what type of contract is best for your business.

Under a firm, fixed-price contract, the outsource provider is burdened with the maximum amount of risk. It has full responsibility for meeting the contract requirements at the agreed-on price. Under a costreimbursement plus fixed-fee contract, the company that is purchasing the outsourced services bears most of the risk. The outsource provider has minimal responsibility for the costs, although its fee (or profit) is fixed. In between these options are contracts in which the outsource provider's profit can be influenced by tailoring various incentive tools to its ability to meet cost and performance targets.

Incentives can help a company and its outsource provider share risks, and they can encourage behavior that is designed to produce the desired outcomes. Researchers at the University of Pennsylvania's Wharton School observed this when they conducted research on performance-requirement allocation and risk sharing.2 Their major conclusions were:

  • Risk-averse companies are more likely to choose contracts that combine fixed payment, a cost-sharing incentive, and performance incentives than are riskneutral companies, which may prefer performancebased approaches.
  • When the company is more risk-averse than the outsource provider, the performance incentive increases while the cost-sharing incentive decreases with time. Conversely, if the company is less riskaverse than the outsource provider, the performance incentive decreases while the cost-sharing incentive increases with time.
  • The allocation of performance requirements and contractual terms changes during the product lifecycle. In short, contracts are likely to evolve, and the mix of contracts will change during the life of the program or the product.

Regardless of the pricing model selected, there is one rule of thumb that applies to all: the pricing model should not provide the service provider with a given profit margin. Instead, the chosen pricing model should be tied directly to the provider achieving the desired top-level performance and cost outcomes

Finding the right incentives
Incentives allow a company to directly influence an outsource provider's profitability by using a predetermined formula that pays additional profit (or reduces profit) based on the outsource provider's meeting agreed-on performance targets. Profits are increased for achievements that surpass the incentive targets; deductions may be made when targets are not met.

A Vested Outsourcing pricing model should incorporate contractual incentives that are mutually beneficial to both the company that is outsourcing and the service provider. Coupling incentives to a contract is not new, but getting it right is easier said than done. The challenge in a Vested Outsourcing contract is to find the right incentives to motivate service providers to make decisions that ultimately will produce the company's desired outcomes. Toward that end, incentives typically are used to:

  • Encourage an outsource provider to attain objectives that are specified in the contract
  • Discourage outsource providers' inefficiency and waste
  • Motivate outsource providers to engage in efforts that otherwise might not be emphasized

The Vested Outsourcing contract should therefore use incentives to balance the downsides of each type of pricing model, as discussed in Figure 3. Figure 4 outlines the different types of incentives you can and should add to a standard contract to help drive performance and cost improvements. Regardless of whether a contract is the cost-reimbursement or the fixed-price type, it should clearly outline the incentive amounts and the formula or methodology for determining those incentives.

It is important, moreover, to establish procedures for assessing whether the provider has achieved the incentive targets and to establish incentives that are not too cumbersome to track and monitor. Administrative costs should not under any circumstances exceed the expected benefits. If something is hard to measure, then you may be suffering from what we call "measurement minutiae."

We are often asked if it is appropriate to use multiple incentive types for a single contract. The answer is, not only is it possible but, in our opinion, it is desirable. A properly structured arrangement should balance multiple incentives, ensuring that perverse incentives are not created and compelling the outsource provider to make trade-off decisions that are consistent with the desired outcomes. Furthermore, a good contract will use the balanced set of incentives to foster an environment in which the outsource provider does not strive to maximize achievement of one objective to the detriment of overall performance.

Contracts should also provide for evaluation at stated intervals (usually monthly), so that the outsource provider is periodically informed of the quality of its performance and the areas where improvement is expected. Correlating partial payment of fees with the evaluation periods helps to create an environment that induces the service provider to improve poor performance or to continue with good performance. In addition, the number of evaluation criteria used in determining whether incentives can be paid, and the requirements they represent, will differ widely among contracts. The criteria and rating plan should motivate the service provider to improve performance in the areas rated but not at the expense of at least minimum acceptable performance in all areas.

Performance and target incentives are integral to Vested Outsourcing. In themselves, they do not create a contract that is performance-based, but they should always be incorporated to ensure that the outsource provider is working toward the proper goals.

Contract duration: Longer is better
So far, we have discussed contract type and incentives. The third essential element of the contract structure is the contract length.

Longer-term contracts are a crucial component of a successful Vested Outsourcing agreement because they encourage service providers to invest for the long haul in business-process improvements and/or efficiencies that will yield year-over-year savings. In many cases, investments in process improvements, such as new equipment or information technology infrastructure, can run into the millions of dollars. Service providers need the ability to forecast their future revenue stream (at least the minimum levels) to determine whether the return on those investments will be reasonable. Accordingly, the length of the contract should be commensurate with the payback period for a service provider's investment.

Long-term contracts may also be needed for the partners to reach the Pony described earlier. Often, achieving step-level improvements in process efficiencies requires a significant investment on the part of the service provider. Without the assurance of a longer-term contract, they are likely to be unwilling to invest in these process efficiencies.

In addition, longer-term contracts offer an intangible benefit to the company that is outsourcing. If the company spends the time to select the right service provider and properly structures the pricing model, it will need to write fewer contracts. The annualized costs associated with writing and developing one 10year contract will be substantially cheaper than the cost for two 5-year contracts, and much less again than for five 2-year contracts. Given the scarce resources within most organizations and the continued downsizing of most corporate functions, it is critical that contracts extend for longer periods of time in order to reduce the time and costs involved in contract development.

Importance of stable demand and funding
The last element of the contract structure should be a mutual understanding of the stability of the demand for the provider’s services and of the funding for the agreement over the life of the contract. Service providers will shy away from making investments in the business if they feel that their potential revenue streams might be reduced during the life of the contract. The price the service provider eventually charges, then, will directly correlate to its level of confidence in its ability to earn future revenue.

If the company and the service provider do not have a common understanding of how stable the future funding will be for the work the provider expects to do, then the service provider likely will add a risk premium to its price. Thus, it is in the best interest of the company to give the service provider solid estimates (and, if possible, minimum levels) of commitment regarding volume and funding.

However, because all organizations face volatility in business and are challenged with budget constraints, the reality is that companies cannot always make firm volume commitments to the service provider. For that reason, we recommend that Vested Outsourcing contracts include minimum-volume thresholds that allow the service provider to cover its fixed costs, or at least create a pricing model that allows for fixed costs to be covered regardless of the number of transactions or business volumes.

Putting it all together: Some general tips
As discussed earlier, it is important to recognize that the outsource provider is and should be a profit maximizer. Consider what you can do to motivate the outsource provider toward behavior that leads to benefits for you, and reward that behavior appropriately. Here is a very brief summary of some additional recommendations on how to do that:

Focus on the big picture. At some point during the life of a Vested Outsourcing contract, someone in finance or senior management may request that the contract be renegotiated because the outsourced provider's gross profit margin exceeds industry norms. Often this person overlooks the investment that the provider had to make to achieve these margins. Make sure everyone understands that one of the fundamentals of Vested Outsourcing is that the service provider earns a larger gross profit by investing and helping the company get its part of the Pony.

Do not cap the incentive. A common tendency in contract negotiation is to reset the baseline savings targets every year. In essence, the company insists that the outsource provider find new cost savings annually in order to earn that year's incentives. Such behavior is not acceptable in a Vested Outsourcing agreement because it leads the provider to engage in "sandbagging": withholding gains that could have been achieved earlier. Cost savings and service improvements should be measured, judged, and incented over the full term of the contract.

Allow pricing models to mature over time. In many situations, it makes sense for the Vested Outsourcing relationship to change and mature. As the service provider gains more experience, the company can evolve to a contract type that transfers more risk (and reward) to the provider.

Include "off-ramps" and reopener clauses in the contract. A central principle of Vested Outsourcing is mutual trust between the contracting parties. Rather than devoting significant effort to negotiating detailed clauses to cover every potential eventuality, a Vested Outsourcing relationship relies on a shared commitment to the agreed, desired outcomes and a willingness to work through challenges together.

Not all contracts or relationships will stand the test of time, however. For this reason, a contract should always include "off-ramps" and reopener clauses. That is, the contract should allow for modifications or cancellation should circumstances change. If the company outsourcing or the service provider is not living up to expectations, the other party should be able to exit the contract without protracted negotiation or litigation.

Implementing a Vested Outsourcing agreement
As important as a sound Vested Outsourcing contract is, it is equally important to implement a good method for monitoring and managing the program once the planning and negotiating have been completed. Managing performance is a matter of having an effective way of monitoring the attainment of metrics and implementing any revisions necessary to ensure success. Without sound measurement tools and accurate reporting of both primary and supporting metrics, the provider risks letting hard-earned profits slip away.

Monitoring and managing should not be the responsibility solely of the company that is outsourcing. Service providers must also be proactive in an everchanging environment, constantly reviewing and adjusting the metrics to ensure a win-win program.

The purpose of the governance structure of a successful Vested Outsourcing agreement is to provide insight, not merely oversight. To provide this insight to the management team, we recommend the implementation of a comprehensive and detailed qualityassurance plan. At a bare minimum, the quality-assurance plan should include:

  • The metrics used to measure the service provider's performance and support outcomes, such as system availability, reliability, and process performance
  • The period of performance on which incentive evaluations will be based
  • The parties responsible for collecting, compiling, calculating, and assessing the metrics
  • The specific data sources from which the metrics will be derived
  • How the metric values will be scored, weighted (if applicable), and prioritized to calculate the amount of the contractual incentive
  • How disputes over assessment data will be resolved

During the start-up period for a Vested Outsourcing contract, baseline data for the program being outsourced often are not available. When that is the case, it is helpful to create a "bridge" contract that allows service providers to assume activities or responsibility for doing the work without requiring it to take on the full risk. Bridge contracts commonly are cost-plus in nature, but service providers are asked to track metrics and develop a solid baseline of performance data. As a program matures, it can use that data to evolve to a business model that shifts the risks and rewards of managing the sustained process to the service providers.

For many companies, a phased implementation is best. In fact, some of the most successful programs we've seen have used an incremental progression approach to adopting a Vested Outsourcing business model. Having a strategy for migrating to Vested Outsourcing rather than suddenly switching from the traditional model to the new one allows both parties to ease into the new method of outsourcing.

Endnotes:
1. Facility Management Pricing Models, Grubb & Ellis Company white paper (2007).
2. "Power by the Hour: Can Paying Only for Performance Redefine How Products Are Sold and Serviced?" Wharton School of the University of Pennsylvania (February 2007): 3-4.

Editor's note: Vested Outsourcing: Five Rules That Will Transform Outsourcing is available from the CSCMP Store for US $29.95 for members ($34.95 for nonmembers).

Excerpted and adapted from Vested Outsourcing: Five Rules That Will Transform Outsourcing, by Kate Vitasek, with Mike Ledyard and Karl Manrodt. published by Palgrave MacMillan, 2010. Reprinted by permission of the publisher.

Kate Vitasek is a faculty member for Graduate and Executive Education at the University of Tennessee, Knoxville's Haslam College of Business Administration. Mike Ledyard is a partner in Supply Chain Visions. Karl Manrodt, Ph.D., is Professor of Management and Director of the Master of Logistics and Supply Chain Management program at Georgia College and State University.

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