Perverse Incentives – Prime Contractors Must Be Incentivised Appropriately

We came across an interesting example of perverse contractual incentives the other day which seemed worth a discussion here. It featured a “prime contractor” type agreement –  where a supplier carries out various services, some of which it delivers directly itself, but in other cases, it buys goods and services from sub-contractors on behalf of the customer. This is not an unusual arrangement, as most readers will know, and often applies in different industries and sectors including defence, IT, and construction.

There is nothing wrong with this as a commercial model, but designing the remuneration and reward mechanisms for the prime contractor requires some care and thought.  If the design is not appropriate, it can encourage, or even force, the Prime into actions that are directly against the best interests of the ultimate buyer. Unfortunately, what we saw in this particular case falls into that category, and sadly for the taxpayer, it was a public body that acted as the buyer.

The core problem is that for the sub-contractor element of the contract, the Prime is rewarded with a percentage fee based on the money it spends with sub-contractors. So when the Prime spends £100,000 with a sub-contractor, the Prime is paid a fee of perhaps 5% (£5,000 in this case) for the work they do in managing that spend.

It’s easy to see the problem here. Firstly, the incentive for an unscrupulous Prime is to spend as much of their client’s money as possible, as that will maximise their own revenue.  Make that £100K into £200K, and the Prime has doubled its own income. Linked to this, there is no incentive for the Prime to actually put in more of its own resource to drive down overall costs, or improving value by getting more for that £100K. The profit to the Prime is income minus costs. So better to spend only £1K executing the £100K contract with the sub-contractor, rather than spending £2K to do that better.

Indeed, if the Prime does what it should be doing in an ideal world, it is hit with a “double whammy”! If it spends £2K and drives the price from the sub-contractor down to perhaps £80K, it makes less income AND has spent more!

So while most Primes want to do a good job for their clients, and the buyer can put certain clauses into the contract that try and encourage the Prime to perform well, this sort of mechanism really works against good outcomes. We’re not today going get into the detail of how you can avoid this, but there are a number of options, including different payment mechanisms for the Prime, based on a cost per activity perhaps, and different ways of incentivising the Prime to work in a way that benefits the ultimate customer (gain-share, target pricing, etc.).

Now some readers might think this is pretty obvious stuff. But this example of poor practice is going on today, in a very large and significant organisation. And it’s public money too. So the message is that despite all the best efforts of CIPS, Spend Matters, the Cabinet Office and many others, procurement capability and understanding still has some way to go in the public sector!

 

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