bookexcerpt 3PLs/LSPs
provider is at controlling costs, the
more profit it can make.
If the actual cost of providing the
services turns out to be less than
expected, the outsource provider
wins because it realizes increased
profit margins without having
passed some of the savings on to its
customer. The opposite is also true,
of course: If the actual cost of providing the services is higher than
anticipated, the outsource provider
loses and the customer wins.
As we have seen, both of these
contract types have drawbacks.
Under both pricing models, potentially perverse incentives may result
in companies’ committing an excessive amount of resources to contract
management.
We often are asked, “Which pric-
ing model is better?” There is no
single right answer. In our work, we
have seen companies succeed with
each solution. In fact, some of the
best solutions were constructed as a
blend of the two, with certain sec-
tions of the work done on a fixed-
price basis and other sections on
cost reimbursement. The parties
must work together to determine
which type of contract will best help
them to avoid outsourcing “ail-
ments” and get to the “Pony”—the
difference between the value of the
current solution and the potential
optimized solution.
The role of risk
Risk is one of the more important
criteria in selecting the appropriate
pricing model. Under a firm fixed-price contract, the outsource
provider is burdened with the maximum amount of risk. It has full
responsibility for meeting the contract requirements at the agreed-on
price. Under a cost-reimbursement
plus fixed-fee contract, the company that is purchasing the outsourced
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services bears most of the risk. The outsource provider has minimal responsibility
for the costs, although its fee (or profit) is
fixed. In between these options are contracts
in which the outsource provider’s profit can
be influenced by tailoring various incentive
tools to its ability to meet cost and performance targets.
Incentives can help a company and its
outsource provider share risks, and they can
encourage behavior that is designed to produce the desired outcomes. The chosen
pricing model should be tied directly to the
provider’s achieving the desired top-level
performance and cost outcomes.
Incentives allow a company to directly
influence an outsource provider’s profitability by using a predetermined formula that
pays additional profit (or reduces profit)
based on the outsource provider’s meeting
agreed-on performance targets.
A Vested Outsourcing pricing model
should incorporate contractual incentives
that are mutually beneficial to both the
company that is outsourcing and the service
provider. The challenge in a Vested
Outsourcing contract is to find the right
incentives to motivate service providers to
make decisions that ultimately will produce
the company’s desired outcomes. The Vested
Outsourcing contract should therefore use
incentives to balance the downsides of each
type of pricing model and to help drive performance and cost improvements.
It is important, moreover, to establish
procedures for assessing whether the
provider has achieved the incentive targets
and to establish incentives that are not too
cumbersome to track and monitor.
The right mix of incentives
We are often asked if it is appropriate to use
multiple incentive types for a single contract. The answer is, not only is it possible,
but in our opinion it is desirable. A properly structured arrangement should balance
multiple incentives, ensuring that perverse
incentives are not created and compelling
the outsource provider to make trade-off
decisions that are consistent with the
desired outcomes. Furthermore, a good
contract will use the balanced set of incentives to foster an environment in which the
outsource provider does not strive to maximize achievement of one objective to the
