August 25, 2010
book excerpt | 3PLs/LSPs

How to write a Vested Outsourcing contract

Vested Outsourcing offers the potential for jaw-dropping savings and efficiencies. But it requires rethinking the way you contract with your supplier for services.

By Kate Vitasek, Mike Ledyard and Karl B. Manrodt

Editor's note: The premise is intriguing: Instead of paying your service provider to perform specific tasks, you pay it to achieve specific outcomes or results—and then provide generous incentives for exceeding those goals. That, in a nutshell, is Vested Outsourcing, a revolutionary new approach to outsourcing.

Advocates say Vested Outsourcing can take outsourcing to the next level, sparking innovation, improving service, and reducing costs. But how do you structure such an arrangement? In this excerpt from their new book, Vested Outsourcing: Five Rules That Will Transform Outsourcing, authors Kate Vitasek, Mike Ledyard, and Karl Manrodt look at the two most common pricing models and explain how to decide which is best for you.

Vested Outsourcing is a new methodology that allows companies to work more effectively with their outsource service providers. Under this approach, they develop service agreements that are based on outcomes, not processes, with added incentives to improve results across a broad spectrum of business metrics. Because the two parties typically share both risks and rewards, they each have a stake in finding opportunities for improvement. Or to put it another way, they become vested in one another's success.

One of the difficulties in choosing the right pricing model for a Vested Outsourcing agreement—one that provides incentives for the best cost and service trade-offs—is that there is often confusion about the different models used to construct the agreement. This confusion is due to the lack of consistency in how terms are applied to specific contract elements.

In this excerpt from our book, we clear the fog around pricing models by providing a basic vocabulary and set of definitions that companies can use to determine which pricing model and incentive types are best for them. In addition, we provide a framework for helping organizations understand the key attributes of pricing models and determine which model to apply to which type of contract.

Basic principles of pricing models
It is important to keep in mind two principles when selecting a pricing model:

  1. The pricing model must balance risk and reward for both organizations. The agreement should be structured to ensure that the provider of the outsourced services (which we generally refer to as the "outsource provider" or "service provider") assumes risk only for decisions that are truly under its control.
  2. The agreement should put pressure on service providers to provide solutions, not just perform activities. A properly constructed Vested Outsourcing agreement encourages the service provider to solve the customer's problem. The better the service provider is at solving the company's problem, the more incentives, or profits, it can earn.

It is also important that Vested Outsourcing teams structure their agreements around reducing the total cost of the process that is being outsourced, not just the costs of the transactions performed by the outsource provider.

Companies often struggle to select the pricing model that will best support their business and still provide the appropriate incentives for the service provider. As we will explain, the pricing model should be based on the appropriate type of contract and the incentives used to reward the outsource provider. Other important considerations are the length of the contract and the prospects for stable demand and funding. The outsource provider will use all four of these factors to calculate the price for its services.

Selecting the right type of contract
< Most companies rely on one of two contract types when building a pricing model for their outsourced business arrangements: cost-reimbursement and fixed-price. In both cases, a company is expected to pay the outsource provider for its costs and a profit for performing its services.

Cost-reimbursement contracts
Under a cost-reimbursement contract, a company pays its outsource provider the actual costs of performing a service. By definition, a cost-reimbursement contract is a variable price contract, with fees dependent on the amount of service provided over a specified time period.

In addition to paying for actual costs incurred by the outsource provider, the company pays the provider a profit through a fixed fee; a variable profit such as a fixed percentage markup linked to costs; or a variable profit tied to prearranged targets.

One of the primary disadvantages of a cost-reimbursement contract is that the outsource provider has no real incentive to control its costs. If the fee is calculated as a percentage of the provider's costs, then as costs increase, the fee increases, too. If the provider manages to reduce costs, it is effectively penalized by reduced revenue and profits.

To address this issue, some companies are incorporating cost-based incentives into their pricing models. In these cases, outsource providers are rewarded with a gainshare in return for reducing costs. The company that is outsourcing and the outsource provider share those savings.

Fixed-price contracts
In a fixed-price contract, the outsource provider's price is agreed upon in advance and is not subject to any adjustments. As such, the price the customer pays is fixed and includes the provider's costs and profit. A fixed-price contract therefore eliminates budgeting variation for the company that is outsourcing. Fixed-price contracts also are the easiest type of contracts to administer because there is no need for the company to keep track of actual costs to determine payment.

This type of contract places full responsibility for costs on the outsource provider. Its ability to manage costs directly impacts its ability to make a profit. The better the outsource 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 pricing 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 sections of the work done on a fixed-price basis and other sections with cost reimbursement. The parties must work together to determine which type of contract will best help them to avoid outsourcing "ailments" 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 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 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 business-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 developing 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 agreement 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 estimates (and, if possible, minimum levels) of commitment regarding volume and funding.

However, because all organizations face volatility in business and are challenged with budget constraints, the reality is that companies cannot always make firm volume commitments to the service provider. For that reason, we recommend that Vested Outsourcing contracts include minimum volume thresholds that allow the service provider to cover its fixed costs or at least create a pricing model that allows for fixed costs to be covered regardless of business volumes or the number of transactions.

Excerpted and adapted from Vested Outsourcing: Five Rules That Will Transform Outsourcing, by Kate Vitasek with Mike Ledyard and Karl Manrodt. Published by Palgrave MacMillan, 2010. Reprinted by permission of the publisher.

About the Authors

Kate Vitasek
Kate Vitasek is a member of the faculty at the Center for Executive Education, University of Tennessee and founder of the consulting firm Supply Chain Visions. She is a regular blogger for DC Velocity on the topic "You might have a bad warehouse if ..."

More articles by Kate Vitasek
Mike Ledyard
Mike Ledyard is a partner at Supply Chain Visions.

More articles by Mike Ledyard
Karl B. Manrodt
Karl Manrodt is a professor of logistics and supply chain management at Georgia College.

More articles by Karl B. Manrodt

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