Incentives play a critical role in in Vested Outsourcing, namely in identifying and achieving the win-win and in encouraging continuous innovation and collaboration. It creates conditions for an incentive mindset and ecosystem, but equally as important, the Vested Outsourcing approach will identify and eliminate those impish perverse incentives.

In a conventional transaction-based outsourcing environment, the emphasis is on conforming to contract requirements and adhering to contract terms. Little incentive, leeway, or opportunity is offered for service providers to explore innovative approaches.

In fact, in many cases, there are significant disincentives to innovation and creativity, many resulting in what I call Ailment #3, the Activity Trap. If pay rates are based on each transaction, it follows that the more transactions that are performed, the more money a company will make, whether the transactions are necessary, or whether there is a more efficient way to do them. There’s no incentive for the outsource provider to reduce the number of non–value-added transactions, because such a reduction would result in lower revenue.

The Activity Trap can appear in a variety of transaction-based outsource arrangements. When the contract structure is cost reimbursement, for example, the outsource provider has no incentive to reduce costs because profit is typically a percentage of direct costs. Even if the outsource provider’s profit is a fixed amount, the typical company will be penalized for investing in process efficiencies to drive costs down. In a nutshell, the more inefficient the entire support process, the more money the service provider can make. Inherent in the activity trap is a disincentive to try to reduce the number transactions, and conversely – or perversely – increase them if at all possible.

A good early example of a perverse incentive based on transactions occurred in the nineteenth-century, when paleontologists traveling to China would pay peasants for each fragment of dinosaur bone (dinosaur fossils) that they produced. They later discovered that peasants dug up the bones and then smashed them to maximize their payments.

Fast forward to the present: On a site visit, when we asked the general manager of a 3PL what a large area full of orange-tagged pallets was for, she replied: “That’s some of our customer’s old inventory I need to move to an outside storage facility.” When we dug further, we found out it was product that was well over five years old and at the rate it was moving, it would be in storage for 123 years! When we pressed further, asking why she did not work with the customer to scrap the material, the answer was: “Why? I charge $18 a pallet per month to store it. I’d lose revenue if I did that!”

Too often the emphasis is on knee-jerk compliance, not continuous improvement or innovation. Service providers that try to introduce new ideas may encounter significant obstacles, requiring complex, costly, and often painful contract modifications.

A properly structured vested agreement based on the Five Rules will take the luck – good or bad – out of incentives.

Under Rule 4 pricing model incentives for cost and service trade-offs will be optimized early-on by all of the parties, while Rule 5 says that a proper agreement governance structure will provide insight on the relationship, not merely oversight. Insight will detect and quickly counter perverse incentives and make sure the pricing model incentives are functioning properly.

Most important in avoiding the propensity for perverse incentives is Rule 1: Focus on outcomes, not transactions.

Don’t let the bean-counter mentality take over.

Most of us grew up hearing about the controversies surrounding the Rocky Flats Plant near Denver, a U.S. nuclear weapons production facility that operated from 1952 to 1992. The 6,200-acre facility was under the control of the Atomic Energy Commission until 1977 and after that the Department of Energy. To make a long, complicated and often amazing story short, numerous violations of federal anti-pollution laws were found there in the late 1980s, including massive water, soil  and building contamination.

That triggered an arduous process of environmental cleanup remediation and restoration, along with the decision to close the facility. It became the Rocky Flats Environmental Technology Site in 1994, and the cleanup effort was contracted to the Kaiser-Hill Company.

During this process, the Contract Management article reports that DOE wanted to “do things differently” in how they contracted for the Rocky Flats closure and cleanup project by providing incentives for the contractor to perform consistently within DOE goals. The department outlined the WHAT and turned to a supplier team of Kaiser Engineers and CH2M Hill, an engineering, consulting, construction and operations firm, to fulfill the HOW.

A short paper on the Rocky Flats closure states the CH2M Hill – Kaiser team “operated under two innovative DOE contracting models” at the site. The first, awarded in 1995, “was the first performance-based contract in DOE,” paying the contractor only for “specific units of verifiable work.”

The second contracting model was the 2000 closure contract, which authorized the entire scope of work to clean and close the site by October 2005 at a target cost of $3.9 billion. DOE originally estimated in 1995 that it would take 65 years and $30 billion to clean up and close Rocky Flats.

No wonder DOE’s drive to do it differently.

Fast forward to 2007, when the cleanup was certified by the EPA as complete; in July that year DOE transferred about 4,000 acres of land on the Rocky Flats site to the U.S. Fish and Wildlife Service to establish the Rocky Flats National Wildlife Refuge. It’s an environmental triumph and a major success for innovative contracting. The Kaiser-Hill contractor team brought innovative approaches to clean up the mess, and the result was that contract incentives for schedule and cost savings resulted in the closure more than a year ahead of schedule and $530 million under the contract budget!

It was a groundbreaking example of performance-based collaboration. DOE’s 346-page Rocky Flats Closure Legacy report says: “Beyond any specific innovation, it was through unparalleled cooperation among the interested parties that a conservative and compliant cleanup and closure of Rocky Flats was enabled; ahead of schedule, under cost, and without a fatality or serious injury.”

The report outlines some major takeaways from Rocky Flats, including:

-      Contract reform works: “The first K-H ‘Integrating Management’ contract demonstrated that incentivizing clearly defined performance measures vastly improved actual results.”

-      What, Not How: Simply put, DOE said it “must manage to a contract, not manage the work for the contractor.”

-      Collaborative working relationships: The closure was a success because everyone was “engaged in the process and supportive of the ultimate goal. We communicated openly and often to seek the best solutions, and came to value the input from formerly dogmatic opponents.”

Those points encompass all of Vested Outsourcing’s Five Rules, especially Rule 2, Focus on the What, Not the How; Rule 3, Agree on Clearly Defined and Measurable Outcomes; and Rule 5, Governance Structure Should Provide Insight, not Merely Oversight.

My take? If the government can turn a political, legal and environmental disaster into something innovative and worthwhile by using collaborative, performance-based relationships, industry should pay really, really close attention.

A recent post on Brown’s Compass Online website from Brad Mitchell, the UPS president of distribution and logistics, proclaims Vested Outsourcing is one of the Top 5 trends in logistics.  Mitchell sings the vested song, to wit: “The key is collaboration. It’s crucial that companies and their vendors, suppliers, and service providers work closely to establish appropriate goals based on business objectives and then create realistic and measurable supply chain outcomes that will advance mutual goals.”

That of course is right out of Vested Outsourcing’s Rule 3: Agree on Clearly Defined and Measurable Outcomes. The vested relationship functions best in a culture where the participants work with each other to ensure their mutual success – the idea is to buy desired outcomes, not individual transactions.

The other supply chain trends cited by Mitchell include, in brief: A focus on security; getting serious about sustainability and going green; outsourcing as a supply chain strategy and a way to free up working capital while focusing on core capabilities; and the continuation of “doing more with less” as the new normal, meaning flexible supply chains, more facility sharing and adoption of multimodal transport strategies.

Jim Barnes, president and CEO of enVista, an enterprise cost management services provider that does supply chain, transportation, ERP and CRM consulting, extols the “power of vested partnerships” recently in his blog.   In it he writes that a colleague gave him the book to read.  “I fully support her message and the book’s overall premise. Vested Outsourcing explores the concept of moving beyond what I refer to as ‘Type I partnerships’ whereby a contract between a supplier and customer is based squarely on price and activity. Vitasek rightly stresses the value and importan(ce) of moving instead to “Vested Outsourcing.”

His post continues at length, but he also suggests that “Vested Partnership” is a “better term than Outsourcing for several reasons … primarily because the end goal in any business partner relationship is to create a partnership based upon transparency, collaboration and improved cost containment or reduction whereby all parties have a ‘vested’ interest in the outcome.” I’m not exactly sure why that term is better, or whether he thinks I should change it (yeah right!) but he concludes his post saying: “I want to thank Kate Vitasek for inspiring me. Her book has validated the importance of Vested Partnerships, the same type of partnership enVista has been consulting on and putting into practice with its own clients for the last eight years.”

So maybe that explains where he’s coming from. I’ll stick with Vested Outsourcing for obvious reasons and because an outsource relationship is something that’s a little different than a corporate partnership. Legal expert George Kimball (author of Outsource Agreements: A Practical Guide) argues the term Partner connotes a legal entity. Kimball’s book because is an excellent guide to the legal and practical issues that can arise from complex outsourcing deals. While I agree in spirit with Jim – I’ll stick to Vested Outsourcing for now!

Let the vested inspiration flow. To paraphrase Sally Field’s famous comment after winning the Oscar: You like Vested Outsourcing! You really like it!

Success in Vested Outsourcing requires engagement of five rules. Here we examine the fourth of those five rules: Optimize pricing model incentives for cost/service trade-offs.

The fourth hallmark of a Vested Outsourcing partnership is a properly structured price model that incorporates incentives for the best cost and service trade-off. A logical pricing structure is essential to avoid ailment No. 1, the “penny wise and pound foolish” syndrome described in Blog No. 1. The pricing model is based on the type of contract — fixed price or cost reimbursement — that will be used to reward the outsource provider.

When establishing the pricing model, businesses should apply two principles:
1. The pricing model must balance risk and reward for the organizations. The agreement should be structured to ensure that the outsource provider assumes risk only for decisions within its control. For example, a transportation service provider never should be penalized for the rising costs of fuel, and a property management service provider never should be penalized for an increase in energy prices.
2. The agreement should specify that the service provider will deliver solutions, not just activities. When properly constructed, Vested Outsourcing will provide incentives to the service provider to solve the customer’s problems. The better the service provider is at solving those problems, the more profits the outsourcing company can make. This solutions-oriented approach encourages outsource providers to develop and institute innovative and cost-effective methods of performing work to drive down total cost while maintaining or improving service. The essence of Vested Outsourcing is a strategic bet by the outsource provider that it will meet the service levels at the set price. Inherent in the business model is a reward for the service provider to make investments in process, service or associated product that will generate returns in excess of contract requirements. Performance partnerships usually are based on fulfillment of the desired trade-off stated by achieving:
• higher service levels at the same cost
• the same service levels at lower costs
• higher service levels and lower cost levels
If the service provider does a good job, it will reap the rewards of greater profitability.
Vested Outsourcing does not guarantee higher profits for service providers; it does, however, provide them with the authority and autonomy to make strategic investments in their processes and product reliability that can generate a return on investment that is greater than a conventional cost-plus or fixed-price-per-transaction contract might yield. Vested Outsourcing also typically seeks to encourage service providers to meet the desired performance levels at a flat or decreasing cost over time. Therefore, the service provider has to leverage its unique skills and capabilities to make the processes more efficient — to the point that it can generate increased profit. By doing so, the outsource provider may earn intangible benefits, such as contract extensions, additional business or locations, expanded services it can offer the partner, or the willingness of the customer to provide references.
Partners in a Vested Outsourcing relationship — the originating company as well as its vendors — should continually seek ways in which to reduce the total cost of the process being outsourced. The interwoven dependencies of outsourcing relationships require an environment that encourages service providers to push outsourcing companies to change internal processes if they are inhibiting the success of Vested Outsourcing. Outsourcing companies also must be open-minded and accountable for driving internal process changes.

The correct pricing model supports the business and provides appropriate embedded incentives. It is important to understand implicitly that the outsource provider is a profit maximizer. This is reasonable, since few businesses are designed to be otherwise. Therefore, companies that outsource contracts to vendors should explore means of encouraging top performance by vendors of outsourcing services, and should reward that performance financially.
Is this approach a risky bet for a company and its service providers? Most thought leaders say no. The profitability potential exceeds possible liabilities. Adrian Gonzalez from ARC Advisory Group, which specializes in supply chain management and third-party logistics, offers this advice: “What differentiates Vested Outsourcing [is] not the risks, which are inherent in any outsourcing relationship, but the potential payoff for both service providers and customers. In other words, the benefits-to-risk ratio is much greater for Vested Outsourcing. And the risk of remaining at the status quo — in terms of lower profits for service providers and continued diminishing returns for customers — trumps them all.”
Organizations can encounter difficulty in attempting to build a dynamic relationship that challenges the status quo in existing processes. But properly structured Vested Outsourcing partnerships can — and do — create paybacks for both parties.
Following Vested Outsourcing Rule #4 prevents the Penny Wise and Pound Foolish and Sandbagging ailments.