DC Velocity - September 2010

detriment of overall performance.

Contracts should also provide for evaluation at stated intervals (usually monthly), so that the outsource provider is periodically informed of the quality of its performance and the areas where improvement is expected. Correlating partial payment of fees with the evaluation periods helps to create an environment that induces the service provider to improve poor performance or to continue with good performance. In addition, the number of evaluation criteria used in determining whether incentives can be paid, and the requirements they represent, will differ widely among contracts. The criteria and rating plan should motivate the service provider to improve performance in the areas rated but not at the expense of at least minimum acceptable performance in all areas.

Performance and target incentives are integral to Vested Outsourcing. In themselves, they do not create a contract that is performance-based, but they should always be incorporated to ensure that the outsource provider is working toward the proper goals.

Contract duration: Longer is better

So far, we have discussed contract type and incentives. The third essential element of the contract structure is the contract length.

Longer-term contracts are a crucial component of a successful Vested Outsourcing agreement because they encourage service providers to invest for the long haul in busi-ness-process improvements and/or efficiencies that will yield year-over-year savings. In many cases, investments in process improvements, such as new equipment or information technology infrastructure, can run into the millions of dollars. Service providers need to be able to forecast their future revenue stream (at least the minimum levels) to determine whether the return on those investments will be reasonable. Without the assurance of a longer-term contract, they are likely to be unwilling to invest in these process efficiencies.

In addition, longer-term contracts offer an intangible benefit to the company that is outsourcing. If the company spends the time to select the right service provider and properly structures the pricing model, it will need to write fewer contracts. The annualized costs associated with writing and devel-

oping one 10-year contract will be substantially less than the cost for two five-year contracts, and much less again than for five two-year contracts.

Importance of stable demand
and funding
The last element of the contract
structure should be a mutual
understanding of the stability of the
demand for the provider’s services
and of the funding for the agree-
ment over the life of the contract. If
the company and the service
provider do not have a common
understanding of how stable the
future funding will be for the work
the provider expects to do, then the
service provider will likely add a risk
premium to its price. Thus, it is in
the best interest of the company to
give the service provider solid esti-
mates (and, if possible, minimum
levels) of commitment regarding
volume and funding.

Kate Vitasek ( kate@scvisions.com) is a member of the faculty at the Center for Executive Education, University of Tennessee and founder of the consulting firm Supply Chain Visions. Mike Ledyard ( mike@scvisions.com) is a partner at Supply Chain Visions. Karl Manrodt ( kmanrodt@georgiasouth-ern.edu) is associate professor of logistics at Georgia Southern University.

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