Outcome-based Contracts Are A Nightmare – Do Them Anyway

July 28, 2016 | Christine Ferrusi Ross

The services industry, and technology industry, are full of ideas that keep coming around. And they often fail several times before they finally succeed. Cloud is a great example, as the groundbreaking successor to hosting and before that timesharing. Many pundits saw the value of renting capacity instead of owning it. The market just needed a few iterations before we found a viable technological AND business model for it.

So here we are, in the services industry talking about outcome-based contracts. Again. Outcome based is pretty important at HfS Research: we think it’s transformative enough to be part of one of the eight ideals of the As-a-Service economy (digital plug and play services require an outcome-based model.) And of course, my first reaction when outcome-based discussion arise is “what’s different this time?”

Here’s what’s NOT different. Outcome-based contract negotiations are a mess. Mostly for some really important reasons in order of when you’ll likely come across them if you want to try outcome based:

  1. You have to know what an outcome is.  Seems simple, and in some cases it might be. If you want to sign a BPO deal for claims processing, that’s not too hard. There’s a pretty standard definition of a claim, understanding of how to process it, and if it’s actually been processed. But if you’re going beyond basic transactional outcomes to broader issues like improved customer satisfaction or higher integrity in your supply chain, then you’ll need to spend a boatload of time defining an outcome properly.
  2. Worse than point one, you have to decide what outcomes matter. As soon as someone gets the idea to do an outcome based contract, someone else in your company will come along and ask “why this outcome? Why not that one?” These kinds of discussions bring out some nasty internal arguments. Because sure, everyone can agree that raising the stock price is important and good. But once you get into more operational metrics, every business unit and every executive has different opinions and priorities to get there. Balancing everyone’s priorities to make sure your contract focuses on the right outcomes is a mess.
  3. Then you’ll get into heated discussions about cause and effect. When you start to get into negotiations with your supplier, you’ll get into a debate about whether the supplier can claim victory in ALL instances, or only if the supplier can prove that the outcome was a direct result of its work. If an outcome happens, was it because of the service provider or external factors? Let’s say a supplier offers to reduce your supply chain costs by 15% through a consulting engagement and one of the categories in the engagement is fuel. The cost of oil drops and now your supply chain costs have dropped – having nothing to do with the supplier. This one will go around in circles for weeks.
  4. What does an outcome even cost, exactly? If you’re paying for outcomes with little-to-no knowledge of the supplier’s cost structure then you have no idea what you should be paying for that service. It’s like cloud – take this price or leave it. So maybe the price seems fair compared to what you think you’re spending internally. During the negotiation, your only real negotiation lever will be if the bid is competitive and you can compare across suppliers.
  5. Making services into a “black box” doesn’t wipe out your regulatory and legal obligations. During negotiations and continuously afterwards you have an obligation to vet suppliers for compliance to government regulation, making sure the supplier operates legally and ethically on your behalf, and follows appropriate security measures. You can’t wipe out this responsibility by saying you only get the outcome. If you only focus on an outcome, you can easily play the “I don’t care how you deliver it” card. But if your supplier achieves that outcome by using slave labor or being noncompliant with regulations, then you’re still liable since the supplier is part of your supply chain.
  6. Post contract, you’ll start to resent your supplier BECAUSE THEY SUCCEEDED. Let’s say the contract agrees to pay on an outcome like volumes of sales and then every time sales goes up you have to pay your supplier. It won’t take long for you to decide you’ve paid them enough, in fact probably paid them two times over what you would have paid in a traditional contract structure. And you’ll turn on your provider – who’s doing an amazing job! (Maybe you put in a stop-clause that agrees to pay on outcome up to a certain amount of money, but that’s more likely for consulting/project contracts than ongoing outsourcing ones.)
  7. Good luck during renegotiation. Remember the point about not knowing cost levers? Chances are your bargaining position will be even worse if you just want to renegotiate because without the competitive bids, you have no basis for comparison. Did the supplier use bots and completely automate the process to get the outcome? Are they primarily labor based? Some combination? If the supplier’s costs are going down, how can you know if you’re getting any of that savings back?

If that’s what’s the same, here’s what’s different: The As-a-Service economy depends on outcomes. Outcome-based contracts used to be something leaders did, and even then only in a few relatively rare situations. But now it’s becoming a requirement. Who has time in this fast moving world where everyone wants to just plug into partners and suppliers and go? Part of being plug-and-play means having an outcome pre-defined and ready to deliver.

No one has time for long complex negotiations. And even though today outcome-based contracts are long and laborious negotiation efforts, if we all keep working on them, we’ll get better at them. We’ll find ways to fix the problems I just listed. Just like timesharing, hosting and cloud, the idea is the right one. If we want to change our businesses and build a competitive future, then we need to start our contracts with the end in mind. We need to focus on what has to get done and not micromanage how it gets done. We’re getting closer as an industry all the time. HfS is working hard on research into this space right now. So when it happens, we’ll get there together.

Posted in: Procurement, Engineering & Supply Chain OutsourcingSecurity and RiskThe As-a-Service Economy

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1 Comments

4 Comments

  1. Pankaj
    Posted Jul 31, 2016 07:06 AM | Permalink Reply

    Thanks Christine. Traditional BPO tasks have always/ generally been treated "Lift and Shift" . The wrapper of outcome based contracts would now make it a pre-requisite for this approach to get better; i.e - do not send a broken, clunky process offshore. We hope:) I particularly liked #6!!

  2. Phil Martie
    Posted Jul 31, 2016 09:57 AM | Permalink Reply

    Nice article. I am on the outcomes boat as well. I especially love point five: the client has to stay engaged because even though they can shift tactical risk (e.g. operational cost overruns), they can't shift strategic risks (compliance, reputation), so must govern well.

    Which leads to a couple of nits I'll pick:

    Item 4: Pricing in an outcomes based contract really has nothing to do with how much it costs the supplier to operate. It is based on value, specifically the incremental value above other options. So clients should be willing to pay 99% margins so long as incremental value is there.

    Missing item: Clients need to upgrade their governance talent to make it work. Otherwise, they'll have no idea how to administrate the deal. They'll miss out on breakthrough opportunities that the supplier can provide because their org cannot absorb it. They'll misinterpret performance, they'll make bad switching decisions, etc. You can't put a new driver behind the wheel of a Ferrari and expect them to get the most out of it.

  3. Richard James
    Posted Aug 09, 2016 10:07 PM | Permalink Reply

    Excellent article, Christine, and spot on with your comment, Phil.

    For me the real challenge with item 4 is not whether clients should pay for value or how much it should cost to create that value but rather in quantifying the benefit it delivers to the client. The traditional gainshare model works in theory where simple direct cost savings (usually FTE reductions) can be share between the parties, but how do you put a financial value on "increased customer satisfaction", for example? And once delivered, as Christine points out, what is the equitable way to share that value so that both parties are incentivised to deliver it? If the service provider takes the lion's share of the benefit then would the client be prepared to risk the investment? But if the buyer wants to have his cake and eat it, what would drive the service provider to offer any innovation in the first instance?

    Often as not, these issues centre around the degrees of trust and opportunism on both sides of the relationship and therefore the point you make around governance, although not unique to outcome-centric arrangements, become critical to the management point.

  4. ASOKE DAS SARMA
    Posted Sep 08, 2016 10:01 PM | Permalink Reply

    Good article. One of the common problems in Outcome based pricing is the impact of various factors on the outcome. Since the outcome (say improving Net Promoter Score) is important to both the client and the vendor, both the parties usually take several initiatives to improve the outcome. At the end, if NPS actually improves, it become difficult to segregate the impact of various initiatives.

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