Outcome-Oriented Contracts for Services: Should You Dangle the Carrot or Wave the Stick? (Part 1)

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In this two-part series, we dip into the topical subject of outcome-oriented (i.e., outcome-based, performance-based) contracts for managing service delivery and outcomes. Part 1 provides an overview of services and outcome-oriented contracts and introduces some specific research on that subject. Part 2 addresses the key findings of that research and provides a set of takeaways from the series as a whole.

Given the magnitude and growth of services spend, procurement’s adoption of such contracts is imperative, but it is also still more of an art than a science. Learning in the school of hard knocks may be inevitable at this stage of the game, but practitioners can also dodge some of the blows by pooling/sharing good practices with other firms and by looking into empirical third-party research. To illustrate the latter point, we’ve chosen to highlight research documented in a working paper entitled, “Using outcome-oriented contracts to foster performance improvements in logistics outsourcing relationships” (Torsten Steinbach, Carl Marcus Wallenburg and Florian Urmetzer, 2017). The paper was recently featured by the Cambridge Service Alliance, which has focused on the increasing role of services in manufacturers business models (i.e., servitization).

Our reading of the research paper suggests that experience and knowledge to design a contract will not be enough to achieve both targeted results and elicit supplier behavior beyond standard performance (i.e., proactive performance, continuous improvement and innovation). Correct contract execution and management will also be necessary. From our standpoint, we would add that success with all but the simplest outcome-oriented contracts will also require the use of fit-for-purpose contract lifecycle management (CLM) technology.

Outcome-Oriented Contracts: Background

Procurement has its work cut out for it when it comes to the management of services spend. According to a recent study published by SirionLabs and Shelby Group, the composition of procurement portfolios at large enterprises has been shifting dramatically from goods to services. “Industry estimates suggest that the aggregate services buying by the Global Fortune 500 has grown more than 4X),” the report states, to $3.36 trillion (56%) in 2015 from $750 billion (19%) in 1995, while goods buying declined to $2.64 trillion (44%) from $3.25 trillion (81%).

While clear statistics are lacking, industry observations seem to indicate a rise in the use of outcome-oriented contracts for managing services delivery and outcomes and delivery. (This trend is particularly prominent in the healthcare/pharma industries but is observable in other industries such as IT and logistics.) Nonetheless, it is still early days, and the design and use of outcome-oriented contracts may be, practically speaking, experimental  for many enterprises and practitioners.

Effects or Side-Effects?

With outcome-oriented contracts suppliers absorb much more risk. And while, in theory, enterprise customers reduce uncertainty about costs and timelines, as well as reduce resources allocated to tracking and managing service delivery, they also must sacrifice visibility and control. In practice, there may be uncertainty in pursuing outcome-oriented contracts, simply because effective design and management of such contracts (which may vary by industry and use cases) is itself uncertain.

At another level, beyond the service delivery execution and achievement of the agreed-upon results, outcome-oriented contracts have the potential to induce positive supplier behaviors (ranging from proactive or continuous performance improvement to an increase in supplier innovation). However, outcome-oriented contracts, if not designed and managed correctly, can also have undesirable consequences.

In many cases, an enterprise can establish a contract which induces cost-minimization and other expedient behaviors, but does not incent a service provider to go further and focus on maximizing the value of the current and future service outcomes. In short, the design and management of outcome-oriented contracts to elicit proactive or continuous performance improvement and supplier innovation is currently a tricky (and possibly risky) business. Being successful will require learning by doing, complemented by acquiring a better understanding of what works (or doesn’t work) and why from shared knowledge pooling and from outside research.

Research Overview

The working paper cited above was based on more than 100 survey responses, focused specifically on the logistics service provider industry (an industry not known for its innovativeness). The findings provide insight into some of the practices that tend to elicit rather than discourage positive supplier behaviors like proactive performance, continuous improvement and innovation.

While not guaranteed, the study’s findings may be more generally applicable, and they may help “to guide practitioners from both buying companies and service providers to design and manage outcome-oriented contracts effectively.”

In Part 2 of this series, we will cover key findings of the research and provide several takeaways for practitioners. To continue to Part 2, click here.

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