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Buyers and vendors, if you've never used incentives in an outsourcing contract, start considering them. They are an idea whose time has come.

Julie Giera, a vice president at the Giga Information Group in Cambridge, Massachusetts, believes they will become increasingly popular because "they are a great way to manage relationships." She predicts the outsourcing world will see a surge of these creative arrangements in the next 18 months.

If a company is going to consider cash incentives, Giera says buyers should use incentives to balance penalties in their service level agreements (SLA). Many companies try "to beat up their suppliers with penalties," she observes. Penalties, of course, are a necessary tool, especially in the application service provider (ASP) arena where venture capitalists "are creating ASPs on a weekly basis with people who have no background in outsourcing."

But if a vendor is producing beyond the agreed upon levels, Giera believes that supplier should be rewarded with a bonus. Incentives not only balance the sting of penalties, but they encourage the outsourcer to invest both talent and money in the relationship. The analyst says buyers receive more attention from vendors when there are cash incentives built into the contract.

Giera cautions the only time a buyer should agree to pay a cash incentive is when the extra performance provides a business benefit. Having a vendor invest the extra cost to increase network availability from 99.96 to 99.99 percent will not make a difference to most customers, for example. "If there's no appreciable advantage, the buyer is throwing money away," she says.

Revenue Sharing Incentives

Many buyers only think about incentives when negotiating SLAs. Giera suggests expanding the concept to special projects or major software changes. Such projects can encompass adding a new business unit to the software or changing an application.

Incentives can be helpful for these types of projects in the ASP world, because this is a new business form that has not had to face life force changes from without. "Completing major projects will separate the men from the boys" in the ASP sector predicts Giera.

Taking advantage of the risk-reward ratio can also be an incentive to the supplier. In the first instance, a vendor agrees to drop its price in return for receiving an agreed upon percentage of the business generated. In today's changing world, vendors are taking part in helping their buyers develop new Web applications in which they want a piece of the profits, for example.

"There are opportunities where this really makes sense, especially if the venture has risk," says Giera. Arrangements like this insure that the success of both companies is tied to the project. 

Sharing Gains

In addition to helping bring a new product to market, vendors are also helping customers to streamline their businesses in return for a percentage of the savings. Giera worked on one outsourcing contract where a global manufacturer asked a global accounting firm to reengineer its business processes so it could compete in today's new world. The outsourcing supplier agreed to discount its standard fee 30 percent in return for 10 percent of the savings.

The accounting firm spent 18 months exploring every nook and cranny, then crafting a new way of doing business for this manufacturer. After the company instituted the outsourcer's recommendations, it saved $250 million. Instead of being thankful for the sizable savings, the manufacturer balked at writing a $25 million check to the accounting company. It chose to ignore the fact it enjoyed $225 million in savings it would never have seen without the outsourcer's work.

Since neither party wanted to go to court, they eventually settled the dispute. The manufacturer wrote a check for $15 million. Needless to say, the accounting firm was unhappy about leaving $10 million on the table.

Giera says these revenue sharing incentives have to be between two parties who trust each other. Suppliers have to trust that their buyers won't back out of their side of the agreement if the numbers become eye-popping. Second, she advocates hiring at the outset of the agreement a neutral third party. The third party audits the results, then signs off on all payments. That way the buyer is assured the vendor performed according to the contract and the vendor knows the buyer can't back out based on the size of the payment.

Incentives are not a one size fits all solution. Buyers and vendors need to work with each other to craft the best solution given the smorgasbord of options available.

Lessons from the Outsourcing Primer:

• Cash incentives serve as a balance to SLA penalties.
• Cash incentives encourage the vendor to invest in the outsourcing relationship.
• Buyers should only agree to incentives if the extra effort on the vendor's part benefits the buyer's business.
• If the buyer is going to share revenue with the vendor, spell out the reward portion in the outsourcing contract.
• Hire a neutral third party to audit the vendor's work, then disperse all payments according to the outsourcing contract.

Publish Date: July 2000

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