Performance Based Contracting:
Performance Pitfalls and Structural Solutions in Outsourcing

by Justin Townsley, 9 July 2003

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In the last article, we described how outsourcing has spawned an industry aimed at making it more complicated, time/resource intensive, and disposed to failure than necessary. We also observed that the practices leading to these difficulties were contrary to principles in contemporary quality management theory. In this article, we’ll review in more detail the issues involved in outsourcing, and how it can be made simple, fast, and successful. The article is divided into two sections: 1) background, and 2) future. The background section reviews the sourcing issue, the theoretical framework for outsourcing, typical approaches, and problems and pitfalls. The future section presents systems and structure analysis of outsourcing, process re-engineering, our recommendations, implementation issues, and case results.

Background

The Sourcing Issue can be presented as a question, “How do I acquire the necessary inputs to my production process at maximum value?” The question is deceptively simple, and there are two classic answers: make or buy. Examining the issue in greater detail, however, leads to interesting insights.

First and foremost, we must answer the underlying, often ignored, and non-trivial question “What is value?” Often, price is the only value component that is considered. This limited view is only appropriate when the item being purchased is a commodity, in the strictest definition of the word. That is, the product quality, quantity, delivery point, delivery schedule, packaging, payment terms, and every other possible consideration of differentiation are standardized. Such a situation rarely exists; commodity contracts are a clear example. Treatment of purchases as if they are commodities, however, is overwhelmingly prevalent. Since outsourcing is only reasonably applied to repeat purchases, or ongoing relationships, this shortcoming is amplified when it occurs in outsourcing processes.

Beyond this matter, however, there are a significant number of theories that can be applied to evaluate the outsourcing process, the relationship that emerges, and the results that are desired. Some of these are game theory, organization theory, agency theory, systems theory, network theory, and complexity theory. An article of this length is insufficient to go into theoretical underpinnings thoroughly, but some of the points of interest will be presented as we go along.

Game Theory.
An important touch point of outsourcing and game theory is the distinction between one-time games and repeated games. One-time games are just what they sound like: exchanges between participants who only meet one time. One-time games are appropriate for purchase order types of acquisition, rather than outsourcing contracts. They are clearly applicable to commodity purchases (rare as those are). They typically involve “zero-sum” situations in which a fixed value is divided between participants. The process outcome often also falls into what we call “Bid and Bash” procedures, and mentality. This eliminates the possibility of building “present value” from an ongoing relationship. It also typically overlooks the explicit definition of the product (or service) being procured, and the components of value in that product or service. It treats the procurement as an entirely static event.

Unfortunately, because the analysis of one-time versus repeated-game circumstances rarely takes place explicitly, too often outsourcing applies the wrong theory to the process. For you game theorists managing supply chains, outsourcing is a repeated game environment. You must consider the present value leverage you can gain through managing the relationship outcome just as the procurement outcome is managed. Furthermore, you must take the time and effort to explicitly define the product or service being procured, and all the components of value that can be attributed to it. Only then do you have a chance of delivering an outsourcing that is sufficiently dynamic to meet the challenges you will present to it.

Organization Theory.
Organization theory is applied to a principal, classic question, “What should be inside my organization and what should be outside?” The classic answer is that when costs of managing increasing complexity exceed transaction costs, the organization should outsource. Alternatively, when the transaction costs exceed the cost of managing internal complexity, insource. This is all well and good except for a couple of points: 1) How can we know what these costs really are? And 2) Even if we can know what they are now, how can we know what they’ll be throughout the future? Our answer to these questions is that the true costs, and the future, are “unknown and unknowable” as Deming said most important things are. Therefore, organization theory is of limited use in this decision process.

Agency Theory.
From the perspective of agency (or contract) theory, the seminal question is, “How do I get what I thought I bought, at the price and terms I thought I agreed to, without spending all my time looking over my supplier’s shoulder?” Depending on your personal vocabulary and perspective, this can be considered a problem with contracting, motivation, structure, or systems. In any event, it presents the second fundamental problem clearly: typical approaches to outsourcing contracts inherently produce perverse incentives, adversarial relationships, and induce needless resource commitments to “contract management.” This second fundamental problem is also a compelling reason why outsourcing fails, or at best delivers sub-optimal results.

The typical approaches referred to above are “Fixed Price” and “Cost Plus….” It is to our detriment that we do not specify “plus what?” The plus is “… A Percentage of Cost.” It should be obvious that a repeated game environment treated as a one-time game by its participants (dictated by the outsourcer, not the outsourcee), will produce an adversarial relationship. A fixed price agreement will incent the supplier to cut corners; a cost plus agreement will incent the supplier to overspend. In both approaches, the presence of the perverse incentive results in excess resource commitment to contract management, which we nickname “contract police.” The reasons for this are the structural shortcomings with the agreement, and the failure to adequately specify both the product and its value.

As a sidelight, lest readers think that the structure of a contract does not affect behavior, be assured that it can; whether it does or not depends partly on the contract and partly on the circumstances. The following examples are useful.

“The Mayor of the French city of Le Lavandou has banned its local residents from dying, as the town’s local cemetery is full.” Fox News 8/27/02

The Sergey Bubka effect. “Ukrainian pole vaulter Sergey Bubka earned $50,000 every time he set a new world record. From 1983 to 1998 he set world records 35 times… never by more than a quarter of an inch.” Internet research.

Systems Theory.
We will leave the realm of theory with this brief comment regarding systems theory. A central part of this theory deals with feedback loops, which can be positive (beneficial) or negative (harmful). When the outsourcing process is short-circuited from the problems cited above, negative feedback loops are built in and harm the outcome, and the relationship.

As you will see below, the recommended approach solves these problems and the foregoing ones, automatically aligns the motives of suppliers with those of customers, and alleviates the resource commitment to contract management, enabling customer staff to concentrate on more important matters.

Future

Systems and Structure Analysis.
The problems with the typical approach, and results, can be summarized as five undesirable conditions:
1. Typical approaches contain perverse incentives (or negative feedback loops).
2. Product and value definition are taken for granted.
3. Customers aggregate expenses for supplier cost and profit.
4. Present value leverage (the ability to build a dynamic, improving, relationship) is ignored.
5. A positive feedback loop is missing (this is different from point 1).

Process Re-engineering.
In order to resolve the shortcomings in the systems and structural analysis, we have to accomplish five things through process re-engineering.
1. Remove the negative feedback loop.
2. Make product and value component definition explicit.
3. Get customers to treat expenses for supplier costs differently than expenses for supplier profit.
4. Utilize present value leverage.
5. Add a positive feedback loop.

Recommendations.
The achievement of re-engineering objectives can be accomplished as follows.

1. Fix the perverse incentives. Change the fundamental contract structure to:
COST REIMBURSEMENT + FIXED FEE
This eliminates the perverse incentive in the structure, and forces the profit-maximizing supplier to focus on maximizing present value profitability. This is achieved by never getting fired. Present value leverage (point 4) is therefore also resolved in this way.

We also recommend that the fixed fee included in this portion of the agreement be somewhat below market norms, to keep the supplier hungry for additional profit. The reason for this will be clear in point 4, below.

2. Make the product and value explicit. Spend the time, collaboratively, during the outsourcing process, and especially during contract negotiations, to establish explicit definitions for the product components and value axes. Investing in this time at the front end of the process will pay enormous dividends in avoided resource commitments, dissatisfaction, and sub-optimal performance costs later.

3. Recognize that the supplier is a profit-maximizer. This in reasonable, since few businesses are designed to be otherwise. Therefore, consider what the customer can do to induce supplier behavior to its own benefit, and reward that behavior with additional profit. For example, the concept of shared savings induces the supplier (in a cost reimbursement agreement) to reduce costs in order to increase profits. The historic problem with shared savings is that it is disconnected from customer satisfaction, which is typically measured but not rewarded, so the incentive is weaker.

4. Add the positive feedback loop of a properly structured incentive. After years of (sometimes painful) research, we have evolved a structure that works extremely well: That structure is:
SAVINGS x CUSTOMER SATISFACTION = BONUS
It should be clear that this entails additional important collaboration during contract negotiations to establish both the process and instrument by which customer satisfaction will be measured. This effort evolves from the work to make the components of product and value explicit, and is well worth the time and resources invested. We recommend that the mechanics of this calculation be established so that the supplier can earn a total fee, including its fixed fee, which is above market, but only if it delivers a superior product (that is, above market customer satisfaction at below market cost).

Implemenation Issues.
Having worked through this process repeatedly over the course of 12 years, we have identified some typical implementation issues that bear mention. They have to do with relapse into the traditional, and counter-productive mindset that causes outsourcing failure. These are:

1. Adversarial relapse. Sometime during the contract negotiation, the parties forget that they are supposed to be collaborators working to a common good. This relapse must be recognized and reversed, or the outcome is in jeopardy.

2. Static relapse. Also during contract negotiation, the parties think that the contract will cover everything that can happen; it won’t. Therefore, concentrate effort on how the contract will govern resolution of unforeseen issues, rather than establishing a static agreement and being forced to choose between ignoring unforeseen issues, or starting the outsourcing process all over again.

3. Zero-sum mentality. This tendency applies across all the points in this section. So much of our business culture and history is hard-wired with this concept that it crops up repeatedly and forcefully. In some processes, we have had to appoint a “zero-sum cop” whose only responsibility is to identify and eradicate symptoms of this mindset.

4. Ratchet on incentive. At some point during every contract negotiation, someone on the customer’s side, frequently senior management, will say “Okay, we pay a bonus on savings for this year, but then next year we start fresh and they have to save more money all over again, right?” Wrong. Savings that are identified and captured earn bonuses for as long as they last, typically the length of the contract. There’s a lengthy mathematical reason why, but the short answer is that this approach costs the customer two years worth of benefits.

5. Focus on fee. At some point during the contract term, someone on the customer’s side, frequently senior management, will say “Okay, they’ve done a good job, but the normal profit in their business is only X percent; they’re making Y!” [Where Y is bigger.] Somebody has to remind the customer that Y profit may be above X, but the total cost of the contract is Z, which is well below the normal total cost in the industry.

Results.
As I mentioned above, FourBridge Partners have been working in this field for more than 12 years. We’ve honed our approach based on study, and stubbed toes. During the first nine years of our efforts, every agreement required some repair within the first six months of its inception. During the last three years, however, every agreement we’ve guided has worked without any repair, or even disagreement. Volumes have been in billions, and the value improvements in hundreds of millions.

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Author:
Justin L. Townsley, Jr. is a Managing Partner at FourBridge Partners LLP, a consultancy specializing in operational and organization performance improvement for firms facing significant challenge. jlt@fourbridge.com, (312) 560-1972

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