Performance-Based Contracts & Outsourcing

Performance Based Contracts

Table of Contents

Outsourcing best practices can be a little funny. It seems that every year, another best practice is promoted by various outsourcing industry experts, only to be replaced by something new the next year. Roughly every five years, the list of outsourcing best practices seems to recycle. What was once old becomes new.

Advice by experts touting the merits of performance-based contracts fits within that cycle. For some reason, we are seeing recommendations for these contracts growing once again. Although they can provide material value to outsourcing clients, it is important to understand what they are, how outsourcing vendors feel about them, and how to make them work for you.

What Are Performance-Based Contracts in Outsourcing?

Mozok Works: Performance-Based Contracts

Although there are many definitions and multiple types of performance-based contracts in outsourcing, the common definition is simple: Provide either a bonus or penalty to the vendor based on the quantity or quality of work done.

Primary Types of Performance-Based Contracts

Within performance-based contracts, two primary categories need to be understood:

1. Pay Per Deliverable Performance-Based Contracts

Pay per deliverable performance-based contracts are fixed fee contracts where the client pays the outsourcing firm a set fee for each deliverable. The terms in such a contract can be a single payment for a completed project (such as the final delivery of a new mobile game developed by a software outsourcing firm) or payment for incremental work (such as payment per customer support call fielded).

2. Pay For Quality Performance-Based Contracts

The second basic performance-based contract type involves variable payment in full or partly based on the quality of the work performed by the outsourcing firm. Frequently, this model introduces the concept of either a penalty or bonus (or both) given the outsourcing company’s performance against the Statement of Work (SOW) and Service Level Agreement (SLA). An example of a pay-for-quality model can be end-of-day reconciliation processing done by an outsourcing firm for an investment bank. Although the outsourcing vendor may charge a flat fee to the bank for the service, the client (the bank) may discount the fee (assessing a penalty) based on low performance as defined in the SLA.

Why Are Performance-Based Contracts Used? Pavlov's Dog

Ultimately, performance-based contracts are intended to incent behavior. The basic concept is certainly not new or rare. Even in our personal lives, we frequently use the concept. We tend to vary tips based on our service at a restaurant. I have two college-aged sons. I learned a long time ago that I should pay them for the work performed and not by the hour.

The same applies to business contracts. Performance-based contracts can improve the quality of the work performed by the vendor- if used correctly.

Nuances in Performance-Based Contracts

Although the top intent for performance-based contracts is incenting behavior, two specific nuances need to be understood:

1. Sharing the Risk

Customers often use performance-based contracts to share the risk with their outsourcing vendor. A common example of this is related to major delivery deadlines. I frequently see some form of a performance-based contract when the client has a hard-stop delivery date. The client will provide a material bonus to the vendor if delivery dates are met. Likewise, the vendor will incur significant penalties if the delivery date is not hit. An example of this can be the delivery of a new mobile game. If the client has a major product launch event planned, they may use a performance-based contract with their chosen outsourcing firm, helping ensure the vendor takes deadlines seriously.

Even if risks are not intentionally shifted to the vendor, performance-based contracts will still force the vendor to assume greater risk ownership.

2. Performance Breakthroughs: Zeno's Dichotomy Paradox

Mozok Works: Performance-based Contracts

In longer-term outsourcing engagements, especially in business process outsourcing, the engagement will naturally reach peak performance levels mid-engagement. Each additional performance gain will require greater effort, take more time to happen, and cost the vendor more to achieve. At some point, it just is not commercially reasonable to improve the engagement’s overall performance.

Outside of traditional outsourcing, this concept is accepted by all. Perhaps a company will pay $10 per month for a gigabit internet connection with a guaranteed 50% uptime. The amount the company is willing to spend for a gigabit internet connection may increase to $100 per month for a 99.9% uptime guarantee. However, the fee mandated by the ISP for a gigabit internet connection with an uptime guarantee of 99.99999…..% may be well over $1 million. At some point, the incremental gain in guaranteed uptime is not commercially viable for either the client or the ISP, and the accepted performance level reaches some form of equilibrium.

Frequently, outsourcing customers will begin pushing performance-based contracts attempting to break through the performance ceiling of an existing engagement. This approach has mixed results if a complete paradigm change in delivery is not included. A new incentive-based contract does not.

Escalating SLAs

One common tactic to achieve a performance breakthrough is an escalating SLA that will force the vendor to improve their performance over time. In a theoretical example, a client may mandate the vendor to increase performance by 5% month over month to comply with the SLA. As with Zeon’s Dichotomy Paradox, there may eventually be an unreachable target, and the vendor will incur penalties regardless of their effort or further investment.

I remember a troubling conversation between a vendor providing ongoing business process outsourcing services and their client. The client mandated an escalating SLA, and the outsourcing company reached peak performance. Each month following that peak, the client assessed a material financial penalty. The vendor was highly frustrated and asked that I help mediate some solution. I spoke with the customer. I asked them how they thought the vendor would be able to improve performance further. The client responded, “we are not the experts! The vendor is… they should know how to do this better….”

The Hatch Outsourcing Vendor Paradox

As the outsourcing business unit head for a Fortune 500 firm, I routinely met with our client executive teams. I had one specific customer that I was especially close to. We had a long-term outsourcing engagement that was performing extremely well. Although rarely needed, we also had a relationship allowing us to have difficult conversations.

In one of our regularly scheduled customer-vendor meetings, the client quickly moved to the topic of a performance-based contract. They explained that they wanted us to assume greater risk ownership and wanted to incent high performance from my greater team.

The topic caught me completely off guard. I admit that it made me mad and hurt my feelings. It pissed me off. We were doing an extraordinarily good job (acknowledged by the client) and carried a large risk percentage. I felt as if my integrity was being challenged. Did they honestly think I needed a carrot or stick to give them my best?

That brings me to the challenge: The Hatch Outsourcing Vendor Paradox. The best outsourcing firms do not need an incentive to give you their best. They will do their best regardless. Outsourcing engagements with lesser or unethical vendors can gain more from a performance-based contract. However, do you really want to work with such companies?

What Do Outsourcing Firms Think About Performance-Based Contracts?

Mozok Works: Performance-Based Contracts

Understanding what outsourcing vendors think about performance-based contracts is important if you want to achieve any material result.

Risk, Effort, and Reward Model

Mozok Works: Performance-Based Contracts

There is a point of equilibrium between risk, effort, and reward, often referred to as a “fair deal.” Within the world of work and our personal lives, we generally accept the concept of a fair deal. If we buy one cup of coffee, we may pay $5. If we order coffee for a team of 10 people, the bill will go up without question. Risk levels also change the balance. A nature photographer may charge $100 to take photographs in a forest. The fee will skyrocket if there is a known man-eating tiger in the same forest.

A customer and vendor can move up or below the point of equilibrium a little, with both parties believing the deal continues to be fair. Paying $6 for a cup of coffee may not raise concerns from the consumer. Selling a cup of coffee for $4, the coffee shop likely will continue to believe the deal is fair.

However, if you materially move above or below a reasonable range by incorrectly balancing all three variables, problems begin. If a party changes one variable materially, other variables must be adjusted to keep the deal viable.

1. Risk Considerations

Outsourcing vendors deal with greater delivery and product cost volatility than almost any other industry. The core product is still largely a person. Of great concern is labor cost throughout a multi-year outsourcing engagement. All outsourcing firms try to predict future labor costs using year-over-year increases in recent history. They rarely predict labor cost increases accurately.

Many years ago, I helped a client choose and build a captive center in Hyderabad, India. Hyderabad was not an outsourcing hotspot at the time of site selection, and labor costs were reasonable. In working with officials in the city, we forecasted labor demand extending five years out. We calculated the year-over-year increase in labor costs in our models. Unfortunately, Infosys and Microsoft announced a significant increase in their stated plans in Hyderabad as we broke ground on the new captive center. Before the center opened, labor costs increased by almost 50% over our predictions.

Further, Murphy’s Law may apply to the outsourcing industry more than any other industry I have been involved with. Humans are just not predictable. I have dealt with an entire team leaving a vendor and accepting a new job with another outsourcing company because the new company gave the team scooters. I had a team quit en mass, leaving for another vendor that gave each employee a certificate noting the employee had been given a more senior job title. I dealt with a team failing to show up to work for a few days because a famous actor in India had died. Most recently, I spoke with a customer dealing with the loss of a team for multiple weeks due to the pandemic. A critical mass of the team contracted COVID.

These additional risks are important to understand. Outsourcing firms assume higher risk than most clientele understand. Outsourcing firms promise to continue to provide services regardless of the human element in the core product. Further, any outsourcing firm’s risk skyrockets with each additional year added to a single outsourcing contract.

The introduction of a performance-based contract significantly increases the risk to the vendor beyond normal. Even if the proposed contract offers the vendor a bonus opportunity, the level of risk is increased. Performance-based contracts change the risk, effort, and reward equilibrium.

2. How the Change in the Risk, Effort, and Reward Model Equilibrium Will Affect You

For most of the past two decades, outsourcing has been capacity constrained- not demand constrained. This dynamic is especially true for Tier 1 outsourcing firms operating in major hotspots. Outsourcing firms typically do not need more business. They need better business.

All outsourcing firms heavily use the risk, effort, and reward model above. Each existing and potential outsourcing engagement is rated and ranked. Even if the client does not change any variable, their rank may still change given what is happening in the market and how other engagements are scored.

Ultimately, all customers requesting a performance-based contract will be reassessed. If the performance-based contract only threatens the vendor with financial penalties without allowing for any change in the reward or scope of work, the score for the customer and resulting rank will drop.

The drop in the equilibrium point for the engagement may easily be material enough that the vendor simply declines the mandate for a performance-based contract and engages another customer.

Hiring a cohesive and highly functioning team in a major outsourcing hotspot is difficult. Vendors take care to set correct expectations with clients that hiring may take months. If the vendor is experiencing friction with any given customer, they are likely to soft-sell the customer’s team to other customers. In most cases, other customers will pay a premium for an existing team that can rapidly start rather than wait a month or two for a new team.  

Be careful in how you structure and propose performance-based contracts with any vendor. If the new equilibrium point in the risk, effort, and reward model drops far enough, the vendor will likely walk out of your contract and sell your team to someone new.

What do Outsourcng Firms Really Think About Performance-Based Contracts?

Vendors do not like performance-based contracts unless there is an opportunity to lift the equilibrium point in the risk, effort, and reward model. Further, the vendor will likely be offended if the client proposes such a contract in the middle of an existing engagement.

However, there are methods to use that can get the support of the chosen outsourcing vendor.

Tricks Outsourcing Vendors Play with Performance-Based Contracts

Mozok Works: Fraud in Outsourcing Performance-Based Contracts

Unfortunately,  fraud rates in performance-based contracts are quite high.

The severity of fraud within these contracts also spans the table. There are numerous minor games played that may not be considered outright fraud. However, there are frequent examples of vendors using these contracts to take significant advantage of the client.

Some specific games of note need to be explained.

The Impossible Service Level Agreement (SLA)

Vendors will often push for an increase in the number of performance indicators measured and the complexity of measurement methods. For argument’s sake, let’s assume there is a performance-based contract that requires the engagement’s performance to be measured weekly. The vendor will bloat the number of indicators measured and create a measurement method for each indicator that takes two weeks of full-time work to complete.

Vendors are very good at seating the fishhook. Vendors note that it is important to ensure highly accurate measurement, warranting more indicators and more sophisticated measurement methods. Customers with limited experience in outsourcing may believe the vendor is doing something special for them. In the end, the SLA can never be used.

No Customer Involvement in KPI Measurement

Vendors will push metric measurement mechanisms that exclude the client. Further, there may not be any method for the client to validate the KPI measurement after the fact. The problem this creates should be obvious. Although not all vendors are unethical, be careful with any SLA measurement that does not involve the client.

Manipulating the Outsourcing Game

Outsourcing firms are phenomenally good at gaming performance-based contracts.

Years ago, I had a large US healthcare client that retained an outsourcing firm to digitize their medical records. The company signed a multi-year contract with a major outsourcing firm to do the work. The contract included a combination of bonuses and penalties based on the monthly volume of work performed.

By the end of the first year, the client noticed irregularities in the month-over-month productivity. The vendor would sacrifice one month by withholding a material volume of work product and would accept a penalty of 5% for that month. The withheld work product would be gradually given to the client over the next three months, ensuring the vendor received a 5% bonus each month for exceeding production targets.

A major US cable television company outsourced its in-bound consumer sales function to a Tier 1 outsourcing vendor. The client included the length of time consumers spent on the phone as one of the metrics used in calculating fees paid. The vendor manipulated the phone system to keep the call timer going well after the potential customer hung up.

Lastly, I worked with a company that outsourced software development on a fixed-fee basis. The vendor was quick to mandate an explicit change control function (as they should). However, the vendor also included high hourly rates the client would pay in the event of a change in requirements. The vendor kept seeding new ideas with the customer once the contract was signed, blowing up the total budget.

Punting: Planning to Fail

Outsourcing firms routinely “punt” a performance-based contract deal.

The vendor will calculate the total delivery cost throughout the engagement. The outsourcing vendor will then add the maximum penalty stated in the proposed contract to their base cost. Lastly, the vendor will tack on their standard margin.

I do not have issues with outsourcing vendors hedging risk in performance-based contracts by raising their standard rates slightly. I have problems with vendors that factor the entire penalty into final rates.

Many vendors that include the full penalty in their base rate assume they will be penalized to the full extent with each invoice. They do not care. They make their target margin regardless. If the vendor meets defined performance standards allowing them to avoid the penalty, they treat the full payment almost as a bonus.

Making Performance-Based Contracts in Outsourcing Work For You

Mozok Works: Performance-Based Contracts

Getting a performance-based contract that provides material and measurable benefits for the client takes work. Much of the work must be done with the active involvement of the chosen (or potential) vendor.

Performance-based contracts are a dance with the vendor. Rather than demanding such a contract, the client needs to earn them with the vendor for the contract to generate high-performance levels.

Prepare

I wrote a paper about the importance of preparation in all outsourcing engagements. I recommend you read through the article.

Outsourcing firms greatly consider additional risk when deciding how to proceed with any performance-based contract. The customer can significantly reduce the risk to the vendor by doing internal housekeeping and operational improvements.

1. Documentation

Document everything in great detail for the given function, process, or product to be outsourced.

For a business process to be outsourced:

  • Map the entire process in depth.
  • Note all inputs, outputs, and detailed specifications for both.
  • Define in depth all performance standards.
  • Document all regulations, laws, standards, and conventions that apply.
  • List all tools, including versions, used in the process today.
  • Capture who is performing the function today.
  • List challenges you have with delivery today and steps taken to improve delivery.

 

For software products:

  • List every feature and requirement in great detail.
  • List all tools and technologies used (including vendors and versions).
  • Document the development, QA, staging, and production environment.
  • Define how you handle code reviews.
  • Note how you handle customer acceptance sessions.
  • Document your entire staging-to-production process.

 

Important to all documentation efforts, the client needs to show that documentation is an accepted and maintained function inside the company and not a one-off effort. Vendors want to know if the customer is sophisticated enough to maintain and use the documentation produced.

2. Improve Internal Operations, Policies, Procedures, and Processes

Do a full assessment of your internal operations, policies, and procedures. I promise you that no reputable outsourcing company will offer you a fixed-fee contract to develop an application if you have no history of managing scope creep well.

To this point, I had a company retain me to be an advisor late in their RFP process. My client had a bidder’s conference and noted they wanted a fixed fee contract. No attending vendors submitted a proposal. After several weeks of calling vendors after asking for a proposal, the client still had no proposals.

The first outsourcing vendor I spoke with noted the client was a “shit show” with no ability to manage or stabilize requirements. The customer was lucky. All vendors involved with the RFP were ethical and simply declined. The customer could have easily been taken advantage of.

Before raising the idea of a performance-based contract with an outsourcing vendor, do an honest assessment of your internal operations, policies, processes, and procedures. At a minimum, customers need to demonstrate maturity with the following:

  1. Risk management.
  2. Issue management & resolution.
  3. Vendor management.
  4. Project management.
  5. Process oversight and management (for process outsourcing)
  6. Requirement collection, management, and change control.

 

Equally important is that the customer must demonstrate that these functions improve the company’s performance and are not “process for process sake” scenarios.

Years ago, I worked with Luxoft to expand internationally. I remember a great customer meeting with a team of Luxoft engineers. Luxoft had recently achieved both a CMM and CMMi Level 5 certification and was quite proud of its achievement. Rightfully so.

The customer knew of this achievement and was quick to boast of their internal process optimization and certification goals. The customer drew elaborate diagrams on multiple large sheets of paper taped to a wall. They then explained how their process optimization efforts would work. The Luxoft team scowled a little, and the customer noted. The customer then challenged the Luxoft team, “what does process optimization mean for you?” The top representative stood up and walked up to the wall with the endless diagrams. He took the last piece of paper with a “finished” box off the wall. He then walked over to the first piece of paper with the “process start” box and taped the “finished” box next to the start. He then stated, “if done correctly, the process makes things easier and faster.”

The above story may be highly oversimplified, but the point stands. You need to show any outsourcing vendor that you have highly mature internal operations, processes, policies, and procedures. You need to demonstrate that they help you be more effective and efficient. They need to prove that you can reduce the risk to the vendor.

3. Involve Your Outsourcing Vendor

If you already have an outsourcing vendor, involving them can be a powerful method for improving the relationship. I promise you that any outsourcing vendor you have been working with knows well your level of operational maturity.

The vendor will know if internal operational, process, and procedure issues affect your outsourcing engagements or increase the risk to the vendor. Include them in any operational or process improvement efforts. You may not need to involve them extensively (although top outsourcing firms are phenomenal at helping customers resolve such issues). Simply including your incumbent outsourcing vendors as advisors will go a long way toward proving that you strive to be a better customer and will reduce their risk.

Prove a Performance-Based Contract is the Best Answer to Real Problems

Performance-based contracts are typically explored when there is a history of performance issues with existing or previous outsourcing engagements. You need to identify the root cause for this underperformance before proceeding.

The problem may be the client. The problem may also be the basic terms of the previous or existing contract.

I dealt with a customer with a series of failed outsourcing engagements for the same business process. Each year or two, the customer would hire a new outsourcing firm. The new vendor would not perform as needed, and the customer would fire the vendor. The RFP process would start all over again.

Each new contract increased penalties for missing stated performance targets. Although penalties increased with each new vendor, performance never met the customer’s expectations.

I spoke with the last vendor to be fired by this customer, and the vendor’s top executive quickly stated, “you can only take so many rivets out of a plane before you don’t want to fly anymore.” The vendor made the point that the specific customer had priced the service very low- removing any headroom for the vendor in the event of an issue. The vendor put junior workers on the project to resolve this challenge and hoped they would deliver at expected levels. The junior workers just could not.

I spoke further with the vendor’s executive team. I heard stories that indicated the client was unorganized, took long to respond to questions, and did not help with training as outlined in initial negotiations with the vendor. Beyond the low rates demanded by the client, the engagement was likely doomed to the dysfunction of the customer. I asked the vendor why they accepted the deal. The executives I spoke with noted they felt they could deliver at first. However, in hindsight, they would have passed.

The above story is a little extreme. Most of the time, problems with the customer’s maturity or terms in the contract are more subtle. If you are struggling with performance in an outsourcing engagement, I highly recommend retaining some third party to give a neutral opinion. If this third party notes that the client (you) may need to take steps to improve or need to align your contracts with current standards, I recommend you take their advice.

If the Vendor is the Problem, Change the Vendor

If the end problem with a current outsourcing engagement is rooted with the vendor, I recommend replacing the vendor rather than pushing performance-based contracts. If the vendor cannot (or is not willing to) deliver at stated performance standards, a performance-based contract is not likely going to change the result. Further, it is relatively less painful and less costly than most realize to change an outsourcing vendor if the customer manages the engagement well.

Do Not Create Fake Problems

Earlier, I noted that outsourcing engagements typically reach a performance plateau. If the engagement is performing well, but additional performance improvements have stalled, question the idea of introducing a performance-based contract. If it is not broken, do not fix it.

Further, avoid the buzz you may feel in the industry about the need for performance-based contracts. If you are happy with your outsourcing engagement, do not create a problem for a new solution.

Build a Real Business Case: Prove a Performance-Based Contract is the Best Solution

If there is a real problem in your outsourcing engagements beyond internal dysfunction or a bad vendor, brainstorm solutions to the problem. If you already have an outsourcing vendor, bring them into the conversation and allow them to contribute ideas.

After all reasonable ideas have been noted and debated, pick the best solution. If a performance-based contract is the best solution, run boldly forth.

Help the Vendor Offset Risk

Preparation goes a long way to offset and prove a reduced risk to all outsourcing vendors. Customers can go further. There are basic steps the customer can take to help reduce the risk to the vendor without any negative impact on the customer.

One common method to reduce the risk of a performance-based contract is a trial run with new engagements. When conducting an RFP, note your intent to sign a performance-based contract. However, include a trial phase with the new vendor with the ability to readdress the terms of the contract at the end of the trial.

The idea of the trial is simple. Pay the vendor a full-time & materials fee for work throughout the trial phase. Run a shadow performance measurement function in parallel, allowing you and the vendor to understand how well the vendor will meet stated targets. Throughout this trial, review how well the vendor is hitting stated targets and work together to address any issues affecting performance.

I studied a software development outsourcing engagement that followed this model. The client clearly stated they wanted to move toward a fixed-fee billing model. The client also offered the vendor a time and materials introductory contract for a trial phase. The vendor submitted an estimate of how much time a given project would take. The customer and vendor then compared the estimated work to reality. The two worked closely together to address challenges that affected estimates. After a few months, the vendor provided highly accurate estimates, and the engagement shifted to a fixed fee model with both parties being happy.

Another method to reduce the risk to the vendor is to shorten the length of the contract or include provisions to renegotiate a multi-year contract if certain criteria occur.

Noted earlier, outsourcing vendors will reasonably predict their exposure over the first year. They know they can deliver and ensure the outsourcing engagement will be commercially viable even with penalty clauses within the contract. However, external factors come into play, and their confidence in the engagement fades with each additional year tacked onto a contract. Allowing the vendor to open basic contract terms, including the rate card, KPIs, measurement methods, etc., on an annual basis can go a long way toward easing their risk concerns.

When customers are willing to do so, they are perceived as being more reasonable. Typically, the vendor will move the engagement up enough within their internal ranking system that the customer will receive additional benefits offsetting any potential risk to the customer. Customers may be given better talent, more involvement from the vendor’s leadership team, etc.

Fear a vendor disillusioned with the customer or is losing money on an outsourcing deal. Do not fear a scenario where the vendor may attempt to take advantage of you in early contract renegotiation. If the vendor perceives you as being reasonable, the odds of the vendor attempting to play a game with you greatly shrink. Further (and, again), replacing a vendor is not as costly or difficult as many think if the engagement is managed well.

Consider a Bonus In Addition to a Penalty

I like to include both a penalty and a bonus in performance-based contracts. From the perspective of both the client and the vendor, I feel including a bonus makes sense.

When clients only include a penalty for missing performance targets, the vendor feels that the customer is simply looking for an opportunity to kick them. There is a real sense that the customer is looming over the engagement.

If the customer provides an opportunity for the vendor to receive a bonus for extraordinary performance, the vendor instantly begins to view the client as being highly reasonable. The vendor begins to do the little things beyond the contract that improves overall engagement. Further, a bonus may be enough for the vendor to commercially justify additional investment into the engagement that can break through performance ceilings. In most cases, bonuses pay material dividends to the customer. After all, if you gain 10% while only increasing cost by 5%, how do you turn away from such a proposition?

Consider a Complete Delivery Paradigm Shift

The shift to a performance-based contract often includes a paradigm shift in delivery. It was common to see customers purchasing dedicated teams for various customer support functions early in the offshore outsourcing boom. As outsourcing firms improved their capabilities, we started to see contracts where the client paid per call rather than a dedicated team. A key aspect of the shift was the bundling of advanced call center infrastructure the vendor provided each customer.

This paradigm shift in delivery is expanding and accelerating. The rise in AI, automation, no or low-code tools, etc., is rapidly changing outsourcing engagements worldwide. Further, numerous outsourcing firms are at the forefront of creating and applying these new technologies in the business world.

Regardless if you are exploring a new act or managing an existing performance-based contract, I highly recommend you have a brainstorming session with the outsourcing vendor on how you can completely change the delivery paradigm. Be open to new ideas.

Continue to have these brainstorming sessions if the conversation does not lead to an immediate change in how the service is done. A breakthrough in the delivery paradigm may well come soon.

Allow the Vendor Enough Time to Realize an ROI

You need to give the vendor time to generate an ROI if the vendor needs to make any material investments to achieve targets in performance-based contracts. If the contract is for a new outsourcing engagement, bidding vendors will have factored in the time it takes to recoup their costs. If you are not getting any bids for your project, the length of the contract may be the issue.

If you push a currently retained outsourcing vendor to accept a performance-based contract, the remaining contract duration may be a real issue. If this cannot be resolved, the vendor will likely walk away.

The only outsourcing engagement in the entertainment industry I had exposure to involved transcoding video. At the beginning of the engagement, the client sent the native video to the outsourcing firm at 1080p resolution. After a few years, native video resolution increased to 8k. The time needed to transcode the higher resolution content skyrocketed, and the vendor struggled to keep pace. The client began mandating a performance-based contract. To hit the new turnaround times, the vendor needed to invest in significant computing power.

Although the vendor was willing to make this investment, the contract was set to expire soon, and the vendor did not have other clients that could use the additional computing power. Given the growing frustration between the client and vendor, the vendor was unwilling to amortize this material cost across some theoretical future contract with the customer.

The vendor discussed the problem with the customer, and the conversation was tense. The two parties circled each other. The customer noted they would extend the contract if the equipment were purchased. The vendor noted they would purchase the equipment if the customer first extended the contract.

The two parties did not agree, and the parties walked away.

Frequency, Timing, and Messaging of a Request for a Performance-Based Contract Counts

If you are beginning the procurement process for an outsourcing engagement and want a performance-based contract, include it in the RFP. Further, outline steps you have taken to reduce risk to the outsourcing vendor and state the business case or justification for the performance-based contract.

When holding a bidder’s conference, listen carefully to how potential vendors discuss the performance-based contract. You need to hear a high level of caution. Be highly skeptical of any vendor who races to accept such a contract without any due diligence.

Throughout the RFP process, vendor interviews, and the engagement phase with your chosen vendor, continue to discuss the performance-based contract. Ask them for their concerns, and address them at length until the vendor is comfortable with the additional risk.

If you are proposing a performance-based contract with an existing vendor, be highly prepared and careful in how you bring up the topic. Make sure you have a sound business case. Give the vendor some time to warm up to the idea. I recommend that you discuss the topic with your outsourcing vendor in your scheduled customer-vendor review meetings. Tell the vendor that you want to put the topic on the table for future conversations. Note your reasoning for bringing up the topic. And ask that they brainstorm ideas on making a performance-based contract work in your next customer-vendor review meeting.

Also critically important: You need to ask the vendor for feedback on what you need to do to make such a contract viable for them. If they come back to you with concerns such as change control, your internal operational excellence, etc., listen to them. Trust me. Immediately after being told by a client that they want to shift toward a performance-based contract, the vendor will not hold back critical feedback.

Involve the vendor in addressing their concerns. Doing so will greatly improve the odds of successfully implementing a performance-based contract with your existing vendor.

Be Reasonable

Just as there are many challenging outsourcing vendors globally, there are an equal number of challenging customers. Be reasonable and ethical with your chosen outsourcing vendor. Outsourcing fails when one party takes advantage of the other. Likewise, the best outsourcing engagements have a reasonable customer and vendor.

When you are thinking about implementing a performance-based contract, be reasonable and consider how such a contract may affect the vendor- especially important when considering such a contract with an existing vendor. Find another option if a performance-based contract places an undue burden on the vendor.

Last Thoughts

Mozok Works: Performance-Based Contracts

I have often been accused of being an outsourcing vendor apologist and performance-based contract skeptic. Both are not true. I consider myself a realist.

After years as a top executive in several outsourcing firms, an advisor to many outsourcing customers, and a researcher in the industry, I have a unique insight into complex outsourcing dynamics. My thoughts on performance-based contracts are largely fact-based, mechanical, and rooted in practicum.

I admit that I have touched many engagements with a performance-based contract that I felt were not healthy. I knew there were better solutions to the problems specific to the given engagement. That said, I have frequently recommended customers adopt performance-based contracts to solve real problems. After all, I regularly use them with my two sons with great success.

Last words of advice….

If you are pursuing a performance-based contract, make sure it is the best solution for a real problem, reduce the risk to the vendor as much as you can, and be reasonable in your dealings with the vendor. If done correctly, performance-based contracts can be a powerful tool you can use to improve your overall outsourcing engagement.