Gain sharing, pain sharing, and the games people play

What? Gain sharing is still alive?

Um, yes it is—at least in the logistics outsourcing world. There are still companies out there that share the savings from productivity improvements with their service providers, although interest in the concept has waxed and waned over the years. Our working thesis is that this happens with almost any concept that turns out to: 1) require hard work, and 2) not be a "magic bullet" solution. Such is our need for instant gratification, as amplified by the demands and expectations of both management and the investment community.

But metaphoric old girlfriends have a way of showing up in new dresses in our business—once-attractive ideas parading among us, rebranded and repackaged. The latest incarnation of gain sharing is "vested outsourcing," a concept with roots in the military.

Our friend Kate Vitasek has done compelling and masterful work in organizing, extending, and communicating the power and potential of vested outsourcing. The basic premise is this: 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.

Realistically, the concept requires truly committed partners in genuine business relationships, with a lot at stake. It's not a casual drive-by process for picking off easy targets.

A rose by any other name
Gain sharing has also been known as pay-for-performance, among other things, and we are confident that the future will bring additional variants. To confuse matters, what's called gain sharing or pay-for-performance takes on different shapes in different environments. One size doesn't remotely come close to fitting all.

At its core, though, the idea is that, as a service provider makes improvements in cost and/or productivity, some of the gain is retained by the provider and some is returned to the buyer of the services.

These agreements can be structured in any number of ways. In the simplest deals, the two parties just split the cost savings. Other arrangements include more elaborate incentive plans, with scaled rewards for various levels of, say, under-budget performance or performance that exceeds KPI (key performance indicator) targets. Then there's the "Olympic medal" model, which allows the provider to earn additional profit by surpassing KPI objectives, with silver-level performance earning a percentage premium over the base monthly charge, and gold earning an even greater premium. Bronze is a break-even, with no premium.

And pain sharing?
In the real world, there's got to be another side of the coin. Gain-sharing programs are no exception. To put it bluntly, a program that rewards for success and fails to penalize for failure is destined for a short, unhappy life.

The Olympic medalists who fall short of the "bronze" pay a penalty to the customer. In some cases of budget-based rewards, a shortfall results in the provider's paying the customer the same percentage it would have gained if the target had been exceeded. This latter example can get to be excruciating for the provider, with an ugly divorce to follow shortly.

What goes wrong?
It all sounds so simple and logical (at least on the surface). Why do these efforts fail, or fall out of favor? There are several reasons.

As mentioned, the one-sided arrangements have built-in time bombs, whether it's the provider or the buyer that momentarily appears to have the upper hand. Other agreements may have advantages for one or the other that take longer to surface, but are still deadly when discovered.

In a distressing number of cases, the parties include gain-sharing language in their agreements but fail to include enough specificity for effective implementation—or mutual motivation. Over the years, the consequent neglect of the potential leads to abandonment.

In one case we know of, the language was a little too specific—and difficult to change. The service provider figured out that it could easily hit the target order fill rate by making a modest over-investment in "C" SKUs (in order to eliminate stockouts) and then under-investing in "A" SKUs to offset the added cost. While these moves saved a lot of money and brought stockouts within the contractually acceptable percentage range, they also led to supply crises with the very items most critical to the client's business.

In a very few cases, and over a long period of time, both parties conclude that there's no longer any meaningful opportunity for improvement. To be candid, too many providers and customers use this as a cop-out for early abandonment when a little creativity and energy might lead to a better-constructed agreement and/or service arrangement.

The biggest problem, in our view? It's that not enough service providers and customers are building the kind of high-trust, high-communications, high-collaboration relationships that will support free and open examinations of the incentives, the disincentives, and their bases. In a notorious case of which we have first-hand knowledge, a customer refused to implement process changes that would save $100 per transaction because it would mean a $50 payout to the service provider's team, for which the customer had developed a visceral hatred. This scenario is played out in less-dramatic fashion every day in many "gain sharing" relationships.

What needs to go right?
As you might imagine, success factors in the various forms of gain sharing are largely the opposite of the things that go wrong.

Foremost is the mandate to build the right kind of business relationship. If a company's DNA compels it to seek adversarial, transactional business relationships, gain sharing should not even be contemplated.

Next is the requirement to be thoughtful about how to build an equitable, two-way-street gain-sharing/pain-sharing agreement, with specifics that are mutually understood—and defined in writing. It follows logically, but seldom does in practice, that the bases and specifics need to be reviewed regularly—maybe annually—for fairness (still equitable?) and currency (what should the new targets be?).

Finally, the joint recognition that the parties are in the game—together—for the long haul is vital. When the low-hanging fruit has been picked is not the time to go looking for another provider. When performance nears optimized steady-state levels is not the signal to go out for a low-price commoditized bid from strangers.

Bottom line
The good news is that our collective interest in high performance and continuous improvement has been sharpened by the challenges of survival in a tough economic climate. More good news is that our information systems are better than they've ever been in terms of providing timely and accurate performance data. So, foundational elements to support gain sharing are—in general—solid.

Gain sharing, under any name, doesn't have to wax and wane, and doesn't deserve abandonment. Done wrong, and/or with wrong motivations, it will disappoint at best. Done right, by companies in the right kind of business relationship, it can pay off for decades.