Procurement Outsourcing – Which Payment Model Should You Use? (Part 2)

In part 1 of our article last week, we looked at the different payment mechanisms that are often used in procurement outsourcing arrangements. In broad terms, they are;

Fixed fee

A transaction or activity based fee

Share of savings

Performance based fee

Each has its positives and negatives, so let’s briefly have a look at how they stack up as options if you are looking to outsource some or all of your procurement activities.

Fixed fee has the great merit of simplicity. The parties will generally agree what the actual cost of running the outsourced activity is going to be, adding in a suitable margin to cover overheads and profits, and that’s it. However, the drawbacks are pretty obvious too. There is no real incentive for the supplier to look to become more efficient, or to seek innovation that might reduce the cost of the operation, or indeed to address the cost of the items they are buying on behalf to the client (if it is that type of category based outsource). So, most fixed fee arrangements need to be - and generally are in practice - combined with one of the other mechanism to incentivise the provider suitably.

A transaction based fee might be appropriate if the work outsourced is of that nature. But a word of warning, as this can also work against the best interests of the client. If we consider many transactions – invoice processing, or even handling requisitions and purchase orders, then the long term goal should probably be to both automate and actually reduce the number of transactions.

We have seen perverse incentives where (for instance) an outsourced service provider refused to work with a supplier to reduce greatly the number of invoices that were generated, simply because the service provider was paid on a “per invoice handled” basis! So be very careful if you are consider a transaction based fee – it can be appropriate, but you need accompanying measures to ensure the supplier’s interests are aligned with your own.

Share of savings – in the early days of procurement outsourcing, this was a common approach. Our perception is that it is used less often now as the main driver of payment, although many contracts still have some element of savings targets in the mechanisms somewhere. It has the great benefit of course that the client does not pay anything – or perhaps not very much – unless and until the provider delivers measurable savings.

However, there are major issues to be considered. Savings measurement is one key issue– unless you are very confident of this, there is a good chance that at least one of the parties will end up feeling unhappy. The client may feel they are paying without seeing the “savings” really hit the bottom line. Or it may be that the service provider feels that genuine savings are being proposed, but the client is not accepting them – perhaps because of poor stakeholder buy-in. So if you are contemplating this route, be very clear on measurement, and define exactly how the “savings” will be defined (and how reward is calculated) in terms of issue such as the difference between proposed, implemented ad banked savings.

Performance based fee – most outsourcing contracts will have some type of performance fee either as the main basis of the payment structure or as an important part of it, perhaps combined with an element of fixed fee. The definition of performance might include service levels; measure of internal customer satisfaction and maybe even supplier survey findings; and achievement of non-financial goals such as corporate social responsibility targets or even supplier innovation. Generally, we would suggest that contracts should contain something of this nature; however, as with any measures that are linked to real remuneration, it is important to make sure they are sensible, measurable, and clear to avoid too much in the way or argument and dispute!

As we said earlier, many procurement outsourcing contracts will include some mix of these mechanisms. The key point is to think carefully about what works for you, perhaps talk to other organisations that have been through similar processes, and yes, ask your provider what their experience suggests. Payment arrangements are an important element in getting the overall outsourcing relationship right, so it is worth some investment in time and effort to get this right.

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