Outcome-Oriented Contracts for Services: Should You Dangle the Carrot or Wave the Stick? (Part 2)


In Part 1 of this series, we provided an overview of services and outcome-oriented contracts, as well as introduced specific research on that subject. Today in part 2 of this series, we cover key findings of the research and explore some of the more practical implications and potential guidance for practitioners.

Below we summarize the research findings published in the working paper “Using outcome-oriented contracts to foster performance improvements in logistics outsourcing relationships” and conclude with a set of takeaways from the series as a whole.

Research: Specific Findings

The following is an abbreviated abstract of findings regarding the effectiveness of positive and negative financial incentives within outcome-oriented contracts and the design and application of KPIs:

  1. Only positive financial incentives (e.g., management bonuses) had a positive effect on the proactive improvement behavior of logistics services providers (LSPs). According to the study, LSPs undertook additional efforts and improvements to “achieve above-standard performance levels and obtain the bonuses.”
  2. Not surprising, perhaps, “linking manager compensation to customer remuneration [had] a positive effect on proactive improvement behavior,” whereas “linking operations staff compensation in the same way has no significant effect.”
  3. Perhaps also expected, penalties did not induce proactive improvement behavior and results that exceeded standard performance levels. An interesting coincidental finding was that potential penalty payments among firms in the study sample were “on average double the size of potential bonus payments.”
  4. The “number of KPIs used to determine LSP performance [had] no significant effect on proactive improvement activities,” suggesting that selecting the correct KPIs was important. Making changes to the performance metric system (i.e., changes in target values or KPIs) over the course of a service contract positively influenced LSP proactive improvement behavior.

The researchers suggested that this last finding “underlines the relevance of the contract management phase, beyond the contract design phase and proves the importance of contractual flexibility to adjust the performance metric system.” They also suggested that customers and service providers “allow frequent adjustments of the performance metric system (e.g., changing the target values or introducing new KPIs) to reflect lessons learned during the contract management phase.” The researchers cautioned, however, that while such flexibility and changes had “a positive bearing on proactivity, other research showed that [numerous] interventions may reduce a provider’s independence and entrepreneurial spirit.”

The researchers also suggested that outcome-oriented contracts should “entail a competitive element,” such that “service providers are rewarded based on their performance relative to historic and competitive data.” Outcome-oriented contracts thus combine two sets of incentives: “cooperative, encouraging co-production with the customer,” and competitive incentives, using benchmarks to determine performance levels.

In effect, successfully managing outcome-oriented contracts requires both the carrot and the stick, but in different proportions, depending upon what an enterprise is trying to achieve.

Key Takeaways

As we suggested at the outset, procurement’s adoption of outcome-oriented contracts for services is now an imperative, despite their still being perhaps more of an art than a science. Therefore, there appears to be no alternative but to move forward with the following in mind:

  • An enterprise’s effective use of outcome-oriented contracts will require moving up a steep learning curve. Trial and error cannot be avoided, but knowledge can be gained from knowledge sharing with other organizations and from outside research.
  • Outcome-oriented contracts are complicated, temperamental creatures. They must be designed and calibrated carefully to achieve desired outcomes. It is both an art and science.
  • Eliciting specific supplier behaviors like proactive performance, continuous improvement and innovation requires positive financial incentives (the carrot) targeted properly, less than “customary” emphasis on penalties (the stick) and an appropriate set of KPIs. Note: If the goal is simply to extract “standard performance” and have a one-off transactional relationship with a vendor, then reverse the carrot and the stick and pile on the KPIs.
  • Eliciting specific proactive performance, continuous improvement and innovation behaviors not only requires astute contract design and development of an appropriate set of KPIs but also a dynamically manageable system of KPIs that will change over the course of the contract management period.
  • The subtle execution and management of such a complex type of contract that must be closely monitored and changed (with the involvement of both the enterprise and the service provider) will require a fit-for-purpose CLM solution. The exception would be an organization with a small number of relatively simple service contracts, which is not the case for larger enterprises.

In conclusion, outcome-oriented contracts are increasingly becoming an indispensable tool for procurement as it seeks to not only get a handle on services spend, delivery and risks but also to elicit proactive performance, continuous improvement and innovation from service suppliers. The first question for practitioners needs to be: What is my goal for this sourcing event and my relationship with a given supplier? If the goal is to extract standard performance with a supplier on a short-term, transactional basis, then the stick and carrot can be applied in whatever proportion is appropriate. But if the goal with a supplier is more strategic, then practitioners will need to master the higher art of calibrating a broader range of variables that include contractual terms, incentives, penalties, KPIs, service delivery and change management and leading-edge technology.

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