Using Contractual Incentives in Performance-Based Contracts

KEY TAKEAWAYS:

• Incentives motivate both parties to make decisions that will meet relationship goals by balancing the economics of the performance between the supplier and customer.
• Incentives provide financial and non-financial benefits to both parties to off-set economic flaws in common pricing mechanisms.
• There are four types of incentives to use in different types of customer-supplier relationships.   

One week before a performance-based contract was supposed to be executed, a client’s senior executive asked contracts to “add some more hooks” to the contract. So what exactly did the senior executive mean by hook?

Many contract professionals are limited and think in terms of liquidated damages by getting a supplier “on the hook” for predetermined financial remedies if a supplier misses a Service Level Agreement, milestone date or something similar.  

What the executive wanted was a better balance of incentives for exceptional service, not just liquidated damages. Incentives and disincentives (usually in the form of liquidated damages) are the fourth element of all performance-based contracts.

Why Include Incentives in Contract

Incentives motivate both parties to make decisions that will meet relationship goals by balancing the economics of the performance between the supplier and customer. Typical pricing mechanisms such as Fixed Fees or Time and Materials have economic flaws that create misalignment between the economics of the work and the required outcomes.

For example, Fixed Fees incent suppliers to make unilateral decisions to make their profit goals, which may mean that suppliers may make decisions to cut corners in the service, if that is what it takes to make a profit target. The relationship goals suffer, and the customer is economically powerless unless the contract includes incentives.

Time and Material pricing acts like a metaphorical “debit card” allowing the supplier to throw “everything” at the problem to fix it without regard to costs. The relationship goals are met, but usually without regard to cost efficiency. Suppliers may make unilateral decisions to assign more people or over purchase materials to make their profit goals.

What is an Incentive

Incentives provide financial and non-financial benefits to both parties. A well-defined incentive encourages both the supplier and customer to beat expectations by working together. Here is a public example from history.

A little over 100 years ago, the Wright Bros. entered into a contact with the U.S. Army to build planes. The contract provided a Target Price, a minimum speed for the plane, a target speed, a financial incentive for each mile per hour (MPH) the plane was able to fly beyond the established target minimum speed.[1]

The Wright Bros. beat the minimum speed and received more money. The U.S. Army got faster planes to fight WWI. That’s how incentives are meant to work.

Four Types of Incentives

There are generally four types of common incentives. Review this list to see how many types of incentives you can include in your next performance-based contract.

1. Reduced Costs

This is the most obvious incentive. Customers incentivize suppliers to better manage costs in the delivery of the goods and services. Typically, a customer and supplier will share any savings when actual projects costs are compared against the budget estimate.  

2. Performance

These can be very effective incentives, but they require a very complete Statement of Work (SOW) and Service Level Agreements (SLAs), or Key Performance Indicators (KPIs). A performance incentive is tied to a quantitative target, such as completing a phase of a project before the deadline. A performance incentive can also be qualitative, such as beating a customer satisfaction target in a help-desk contract (qualitative).  

3. Award

These incentives are helpful for a one-time agreement to meet a one-time goal. As opposed to SLAs that endure for the life of the project, not just the life of the contract, an award inventive is appropriate for a shorter-term agreement. At the conclusion of a one-time agreement when the supplier meets the one-time goal, the supplier gets a financial bonus. These are helpful when the nature of the work makes it challenging for the parties to set predetermined SLAs at the time of contract execution.

4. Additional Contract Duration

These incentives can be overlooked as a type of incentive. However, they are equally powerful incentives. This incentive is invoked when a customer chooses to extend a supplier’s contract for another year or two when a supplier demonstrably meets or exceeds a performance target. This incentive reduces transaction costs to both parties by tying the contract duration to performance, not just convenience.  

Examples of Incentives in Agreements  

Here are two suggestions to include incentives in your next performance-based contract.

Software Development

Considering combining an incentive for reducing costs with a performance SLA. These incentives can be very effective to help balance the drive to reduce costs at the expense of meeting a SLA, or meeting a SLA at all costs.

Delivery of Goods or Services

Milestone payments for meeting a critical path date that is tied to a supplier’s profit. This means a supplier may be eligible for a payment for completing a task or delivering a good, plus a payment categorized as an incentive (profit) for meeting or beating that milestone date. Again, this type of incentive balances the need to meet or beat the milestone date with the supplier’s desire to make additional profit.

Are you intrigued to learn more? Stay tuned. Each month right here, I will provide more information to help you draft, negotiate, and manage performance-based contracts. If you want the manual to learn at your own pace, purchase your copy of The Contract Professional’s Playbook: The Definitive Guide to Maximizing Value through Mastery of Performance- and Outcome-Based Contracting.     

[1] (Ref: The Vested Outsourcing Manual by Kate Vitasek, page 185).