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.

By Stephanie Overby
Wed, April 29, 2009

CIO — 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."

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