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Penalties and Incentives in Outsourcing Contracts

Financial penalties and incentives can play a key role in managing an outsourcing partner. By effectively defining penalties and rewards tied to specific business objectives, clients can create powerful incentives to work towards mutually beneficial goals. It boils down to setting basic vendor and client expectations. The client must make it clear that there are financial consequences if those expectations are missed and encourage excellence through financial incentives.

Let's first review incentives, which are in many respects more difficult to get right than penalties. Incentives can enhance motivation and thus results, and foster a healthy outsourcing relationship if both parties stand to gain. But incentives done incorrectly can also lead to a supplier skipping corners to achieve the goal. It's essential that the incentives are clearly defined, communicated, agreed and tied to business objectives. Vendors should be rewarded for displaying behaviour above and beyond the standard services you are procuring i.e. identifying productivity gains or reducing transaction cost, implementing ideas that contribute to business success. Achievements bonuses as defined on sourcingmag.com "are typically one-time payments for reaching certain milestones. These may be tied to earlier-than-expected completion dates, higher-than-committed critical service levels (only if this overachievement adds additional value to the client), or better-than-expected throughput." Incentives should also include bonuses for both vendor and client personnel for outstanding team work, ensuring that both sides are motivated to work together. One of the most common reasons for outsourcing engagements not achieving their milestones on time is due to lack of collaboration, so its important to reward teams on both sides for demonstrating that value consistently.

The basic premise behind penalties is not to find ways to pay less for a service, but rather to prevent poor service from occurring in the first place. If a vendor misses client expectations that were originally agreed in the contract, the penalty should produce a change in behaviour that not only fixes the problem, but also ensures it is not repeated in the future. Penalties should be substantial to prevent complacency and sloppy work and for repeat transgressions the financial pain should escalate and increase with each repeat occurrence, up to a specified maximum. As commented on sourcingmag.com "This is essential to motivate vendors to focus attention on problems early and fix them. Penalties should be paid in the month after the failures occurred - and not tallied for reconciliation at year end. Otherwise, the direct connection between poor performance and the penalty is lost, as is the sense of urgency to take corrective action. It's generally a good idea to define penalties so that they reflect the relative importance of the services involved; in other words, the more critical the service, the tougher the penalty if that service suffers. Penalties can also be tied to trends, so that a downward trend over several months gets penalized, rather than any one particular anomaly. Vendor staff turnover can trigger penalties if staff continuity is a priority; this can discourage service providers from reassigning staff to other clients".

It is important that any loopholes in the contract are closed due to well defined penalties. It is best to avoid spreading penalties out over too many targets as it reduces the ability to have an impact on top priorities (e.g. a single miss will only be a minor financial impact on the vendor.) By contrast, having some large targets the vendor will feel a single miss a lot more and there should be a large incentive for them to change behaviour and strive for quality. As commented by Geraldine Fox from Compass Consulting, "Effective penalties motivate vendors by making them focus their efforts on what's really important to the business. Each miss in critical service areas should produce a deeply felt impact. Put differently, given a penalty "budget" of 15 percent of the contract price, knowing where to "invest" that 15 percent is the magic formula. A vendor who faces a 10 percent penalty for missing a service level target will direct considerable energy and enthusiasm to ensuring that target is never missed. And don't worry about setting stretch targets - studies demonstrate that challenging service levels are more frequently attained than easy ones."

Penalties and incentives are useful tools if applied correctly. They can build effective and successful outsourcing deals. Consistency in aligning expectations of all parties involved, then clearly defining tangible goals and penalties to avoid disagreement further down the line is key to making it work. Incentives can be used as a tremendous force to reward good behaviour and penalties can be applied to stop silly mistakes from re-occuring. It is about striking a healthy balance between incentives and penalties and then ensuring you don't manage the vendor by using the contract but instead through a healthy dynamic two way relationship. 

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