The Good, the Bad and the Ugly: 10 Tips for Outsourcing Incentives and Penalties that Work

The incentives and credits written into an IT services contract are critical to the long-term success of an outsourcing deal. But overly broad, ambitious, or punitive provisions can prove ineffective--or worse--injurious to the client/vendor relationship.

Reward good behavior and punish poor performance. Sounds like a commonsense approach to achieving results. And if that tactic works in the chaos of the kindergarten classroom, it seemingly couldn't hurt in achieving desired outcomes when outsourcing.

Indeed, incentives and penalties (technically called "credits" for a variety of legal and connotative reasons) have been an important part of IT services contracts since the first deals were inked fifteen years ago. And today, the establishment of well-defined service levels and associated incentives and credits are more important than ever as customers turn to "results-based contracting and to multi-supplier sourcing strategies," says Dan Masur, a partner in the Washington, D.C. office of law firm Mayer Brown.

The good news is that outsourcing experts have figured out ways to make these financial motivators—which usually appear in basic terms in the master services agreement and in more detailed form within service level provisions and pricing exhibits—more meaningful. "The trigger, amount, and frequency of financial incentives have become much more closely aligned to the actual risk that the incentive is meant to mitigate, thus providing better incentives to both customer and service provider," says Mike Slavin, partner and managing director of CIO services for outsourcing consultancy TPI.

Customers are catching on, putting more teeth into their incentive mechanisms and leveling the playing field during negotiations, according to Bob Mathers, a principal consultant in Compass Management Consulting's Toronto office. Today's IT leaders signing second and third generation outsourcing deals "have a good grasp on penalties and incentives," Mathers says, "but only because they didn't do it right the first time. Very few organizations get it right the first time."

Service levels and related credits for unexcused failures today are "energetically negotiated," says George Kimball, partner in San Diego-based law firm Baker & McKenzie's global IT and telecommunications practice. But IT services customers must exercise caution during deliberations. Provisions that are overly broad, purely punitive or poorly thought out will be ineffective—or worse—injurious to the relationship, a Cadmean victory for the client that imposes them.

"At the end of the day, penalties that providers are reasonably willing to accept will only be a fraction of the cost of your business failure," says Ben Trowbridge, CEO of outsourcing consultancy Alsbridge. And no penalty can heal a bad outsourcing arrangement. "Many times poor performance is the result of either incorrect expectations or a commercial model that encourages the wrong behaviors," says Edward J. Hansen, a partner at Morgan, Lewis and Brockius. "The most dangerous misperception is thinking that massive credits can correct a poorly thought out deal."

Understand these dos and don'ts for setting up outsourcing incentives and credits that work.

DON'T include many incentives or credits. "Not everything that can be measured and reported is worth tracking, and not everything worth tracking should necessarily bear financial consequences, says George Kimball of Baker and McKenzie. "Suppliers will put only so much at risk." Most contracts put a cap on credits as a percentage of annual contract value. "If you have 20 service levels that are subject to penalties, the cost impact to the vendor of defaulting on any one of those penalties can be minimal, but the impact of that default to the business may be significant," says Mathers of Compass. "In the most severe of cases, the penalty may be so low that it is cheaper for the vendor to ignore the problem rather than fix it."

DO create incentives and credits that are targeted and readily measured. The devil is in the details. For example, 99 percent server availability may seem like a good target, but "if there are 100 servers, one of them might be stone dead without tripping the service level," says Kimball. "Better to measure availability both overall and specifically." But be wary of too much complexity. Keep metrics and calculations as simple as possible. "Effectiveness includes clarity and ease of administration," Kimball says.

DON'T be punitive. "Credits should either reasonably compensate the customer for degraded or missed services, or provide incentive for the vendor to perform against what would otherwise be its own natural interest," says Hansen of Morgan Lewis. The goal should not be to punish but to "prevent problems from occurring in the first place and, failing that, should produce changes that fix the problems and increase the probability of repeatable successes in the future," says Mathers.

DO look beyond SLAs. Good incentives should give the vendor a stake in business outcomes, says Hansen. Business value is more difficult to quantify, so customers must identify clear performance indicators that, if met, delivers the desired results. "Too few customers consider custom metrics for their business," says Kimball. "Measurements tied to key business processes, such as shipments or deliveries, take time to develop but may be much more important to the customer's business than, say, server availability."

DON'T provide incentives for simply exceeding a service level. No business benefit, no vendor payout. "Why should clients pay a bonus for services they're already paying to receive?" says Hansen.

DO approach "earn-back" provisions with caution. "Earn-back" mechanisms allow vendors to win back credits if they improve service over time. While not inherently bad, they can wipe out the original penalty, taking teeth out of service credit clauses. "They (can) allow the vendor to compensate for deficient performance on a critical service by over-delivering on services that the business doesn't really care about," says Mathers. Forgiveness of prior failures and refund of credits paid should be tied to sustained improvement and the absence of other serious failures.

DON'T leave incentives and credits in the negotiating room. "The specifics of any formal incentive program should be clearly documented and communicated to all who can potentially contribute and benefit," Mathers says. When cash incentives are paid, ask the supplier to pay a large portion of the money to staff assigned to the customer's account. "This helps to attract and retain the supplier's best people on the customer's account," says Kimball. But on the credit side, know that, failures themselves, reported up the chain of command, matter more to the client account team that the precise amount paid by the vendor.

DO close credit loopholes. You don't want the vendor to decide that it's cheaper to pay a service level credit than fix a recurring problem. Masur recommends that service level terms provide for the doubling of service level credits for three or more consecutive service level defaults, permit the customer to shift credit dollars to service levels receiving insufficient supplier attention, and include termination rights tied to chronic service level defaults.

DON'T save up incentives and credits until year-end. "Penalties should be paid in the month after the failures occurred," says Mathers. "Otherwise the direct connection between poor performance and the penalty is lost, as is the sense of urgency to focus attention on the cause."

DO be realistic. Don't create overly stringent standards of service unless they are both necessary and achievable, says Kimball of Baker and McKenzie. Not every function or operation really requires "fail-safe" reliability. Redundant systems, 24 x 7 support, and the rest cost money," says Kimball. "These 'wish lists' may not represent good value and suppliers will not sign up for service levels that they cannot consistently meet or exceed." Exceptionally stringent targets may translate into premium rates.

This story edited by Shawna McAlearney. Follow me on Twitter @ms_shawna

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