What Makes a Good Governance Structure?

In our Vested Outsourcing work, a major focus is governance.  A poor governance structure can drive a good outsourcing relationship into the ground.  Research by the Corporate Executive Board shows that poor governance can erode up to 90% of the business value anticipated for an outsourcing agreement.  The Outsourcing Center reports that governance plays a role in 62% of outsourcing relationship failures.

But what does a good governance structure look like?

A governance structure has to do three key things for a company and its service provider:  Clarify expectations, align goals, and adapt to business changes.

As legal scholar Ian Macneil has said, the reason most outsourcing contracts don’t define good governance structures (or, often, any governance structure at all) is because the traditional contract template is designed for simple transactions, not collaboration, over short time frames, not years.

The biggest single flaw in the traditional contract template is that it assumes a static environment.  That’s fine for a one-time transaction.  Get beyond that and you’re in a dynamic environment.

The second biggest flaw is that governance implies collaboration.  The traditional contract template is designed to manage risk and enforce terms and conditions.

Macneil tells us that a contract should be an instrument for cooperation, providing a flexible framework with clearly defined objectives, measurable desired outcomes, a baseline, and a process for managing change.

In their white paper “Upacking Outsourcing Governance:  How to Build a Sound Governance Structure to Drive Insight Versus Oversight,” authors Kate Vitasek, Gerald Stevens and Katharine Kawamoto provide this working definition of a governance structure:  A framework and joint process that encourages ethical, proactive changes for the mutual benefit of all the parties.

How do you build it?  Well, assuming you and your outsourcing partner are coming into this process with a collaborative, “what’s in it for we” mindset and a high level of trust, here’s how I’ve distilled Vitasek et al’s recommendations:

·      Establish mutual and shared accountability, and consider the end-to-end process outcomes of the combined entity.  It takes both the company and the service provider to produce the outcomes.  Think of the two as a single entity.

·      Create a “reverse bow tie” management structure with a clearly defined escalation process.

·      Drive a disciplined business review process focused on two things:  understanding what is happening and why, and developing transformation and continuous improvement initiatives.

·      Define, in detail, an exit strategy reflecting the reality that for any number of reasons (such as acquisition) the parties may need to end the relationship.

It’s not easy, and good governance requires an investment of time and money.  At its simplest, good governance involves stepping back from the day-to-day firefighting to take a long view, looking broadly at the end-to-end process and looking forward to anticipate the future.  Many companies that have established effective governance structures dedicate at least one person in each company full time to managing the governance process.

That might sound expensive, but go back to my first paragraph.  Poor governance kills most of the value of an outsourced relationship.  Good governance starts with a good structure, but it needs time and attention to pay off.

I’d like to expand a little on the first three of the four bullet points above.

The concept of mutual and shared accountability reflects the reality that the success of an outsourced service relationship absolutely depends on both parties working together.  If you just throw the tasks over the wall at the service provider and expect them to do everything, and blame them when things go wrong, you’ve started the death spiral.  I’ve met dynamic duos of managers, one from the company and one from the service provider, whose bonuses are tied to the same metric.  Together they succeed.

That degree of collaboration and commitment starts with the reverse bow tie management structure.  Instead of funneling all decisions through a SPOC at each company, assign two people, one from each company, to be responsible for a subset of the overall activities.  Vitasek calls this the “two in a box” structure.  The success of each “two” depends on working together to achieve a defined business outcome.  The escalation path should be also “two in a box,” all the way up to the two CEOs.

That might seem anathema to traditional procurement organizations that use market power to dominate their service providers.  But Vitasek, with co-authors Mike Ledyard and Karl Mandrodt, documents the importance of this shared accountability – all the way to the top – in the extensive research on successful outsourcing relationships embodied in their book “Vested Outsourcing:  Five Rules That Will Transform Outsourcing.”

As I wrote in a previous post, this is not about playing nice.  It’s about playing smart, learning from the failed relationships and the successful relationships.

The business review process should have four components:  service delivery management, transformation management, agreement compliance and relationship health.  Ideally, these tasks should be divided among four individuals, because the disciplines and activities in each are quite different.

Service delivery management is about managing the day-to-day business, understanding what is happening and why.  The “why” provides the fuel for continuous improvement initiatives.  This process must also provide a forum for addressing problems, including grievances raised by either side.

The transformation management process should be focused on the end-to-end process of the combined enterprise.  It should develop, evaluate and choose initiatives based on fact and data, with a long-term view.  And it’s incredibly important.  As Nobel Prize winner Robert Solow has shown, 87% of all economic growth comes from process transformation – not new products, just process.

Put your smartest people in charge of the transformation management process, because that’s where you will find the most upside.

The agreement compliance process needs to be disciplined.  It’s too easy to make a decision and go without documenting and, at times, amending the contract.  It’s an essential element of protecting the overall enterprise from disruption caused by personnel changes that can bring changes in attitudes and approaches.

Relationship health reflects the fact that business relationships are built on interpersonal relationships.  Vitasek et al describe a process illustrated by Whirlpool that looks at five elements of the relationship to assess its overall health:

1.     Communication.  Is it open, honest, adequate and timely?

2.     Responsiveness.  Do the parties do what they say they will do?  Do they demonstrate joint efforts and joint problem solving?

3.     Problem-Solving:  Do the parties work together to eliminate barriers to change and align key processes?

4.     Service Provider Profit:  Is the service provider getting rewarded for above-and-beyond performance, and getting compensated for investing in transformation initiatives?

5.     Working Relationship:  How do the parties evaluate themselves and each other, up and down the management levels?  What do internal or downstream customers have to say?  What do external customers have to say?

I don’t know about you, but item 4, Service Provider Profit, made me say “Whoa!”  An outsourcing company concerned about their service provider’s profit?  It makes sense, though.  The outsourcing company’s success depends on the service provider’s success, and the service provider’s success depends on its ability to generate profit growth.  And if the biggest upside from the relationship comes from process transformation, what better way to keep the two parties’ interests aligned?  Provide the biggest rewards to the service provider in the form of profit gains in return for successful transformation initiatives.

A structured and staffed governance process provides the framework for that success.  More at the Vested Outsourcing website.

Is Collaboration Nice or Smart?

In recent history, the dominant procurement strategy boils down to this:  Use your economic power to strip margin from your vendor.

It’s been argued that GM went bankrupt because it stripped margin from its supplier base.  GM took that strategy so far that many suppliers went out of business.  As a result, GM was forced to buy parts at a premium, or accept lesser quality, or less reliable delivery.  All along, GM thought it was getting better prices.

I’ve personally witnessed such a debacle, when I worked for a service provider that accepted a no-margin contract.  After the contract was in place, the client used its economic power to force price concessions.  My company stayed in the game, believing the prestige of having that client would help it win more clients.  It didn’t work out that way.  The service provider went bankrupt, giving the client almost no notice.  The client suffered damage to its reputation when a substantial portion of its supply chain vanished, almost overnight.

And on the way down, the service provider used every method it could find to cut the cost of its services.  Those cuts affected quality.  The pressure to extract margin from the business resulted in behavior that bordered on the unethical.  At best, it was passive aggressive.  At worst, people lied.  Of course they would do this.  The service provider was in the business to make money, and their investors, just like the client’s investors, demanded profits.  The gamesmanship was unsustainable.

Everybody lost.

What drove the client’s behavior was a culture of intimidation.  They were convinced that collaborating with the service provider, working together to achieve a common goal (including profit growth), was a bad idea.  They were openly dismissive, calling it “playing nice.”

Professor Robert Axelrod of the University of Michigan has science and evolutionary biology that shows they were wrong.  He pioneered research into what’s become known as The Prisoner’s Dilemma, and proved that collaboration is the best strategy.  It’s not about playing nice.  It’s about playing smart.

The classic illustration of the Prisoner’s Dilemma is this:  If I rat out my co-conspirator and he rats me out, we both get five years.  If I rat him out and he says nothing, he gets 10 years.  If I say nothing and he rats me out, I get 10 years.  If we both say nothing, we both get six months.

To have a shot at the best possible outcome – only six months – I have to say nothing and pray the other guy says nothing too.  But if I say nothing and he rats me out, I get 10 years!  We’re not allowed to talk to each other.  Can I trust him to not screw me over?  How well do I know him?

What would you do?

In negotiating an outsourcing relationship, we have a different scenario.  Unlike the two prisoners, we can talk to each other.  And if the two prisoners are allowed to talk to each other, they would of course collaborate.

Professor Axelrod has spent his career applying his research in business and international diplomacy.  Some credit him with the thinking that allowed us to survive the Cold War and prevent nuclear devastation.  He has shown that a strategy of collaboration, combined with a willingness to retaliate, produces the best long-term outcome.

The willingness to retaliate?  Yes.  In your negotiations with your outsourcing partner, you should be quite open about how you will respond to violations of your trust.  Talk frankly about the fact that you must make a profit.  For the sake of illustration, if the client company tries to extract margin by forcing a price reduction, the service provider will respond by cutting quality in order to protect margin.  If the service provider tries to boost its margin by cutting quality, the client will retaliate by terminating the contract.

If we take margin from our vendor, they will find a way to get it back.  They will do it openly, by generating enough scale that they become the 900-pound gorilla, or they will do it quietly, through passive-aggressive behavior.  Either response amounts to retaliation.  And we will always come out worse off.  Both of us.

How to use collaboration to maximize profits for both players is what Vested Outsourcing is all about.  Just as Professor Axelrod used research to demonstrate the power of collaboration, so have co-authors Kate Vitasek, Mike Ledyard and Karl Mandrodt used research to show HOW to create, document and manage a successful collaborative outsourcing relationship.  Read about it in their book, “Vested Outsourcing:  Five Rules That Will Transform Outsourcing.”

It’s not about playing nice.  It’s about playing smart.

To hear Professor Axelrod discuss his research, visit RadioLab.

For resources to implement a successful collaborative agreement, visit Vested Outsourcing.

Book 2 Review

Many thanks to Kathleen Goolsby for her review of our new Vested Outsourcing book (we call it Book 2).    The book is almost here; pre-order at Amazon.  Available in both hardback and Kindle.

Contract Terms to Drive Innovation

A client asked me last week what terms or clauses he should build into his outsourcing contract to get the service provider to generate more innovative solutions.  I wish I had an easy answer.

I believe the place to start is WITH the service provider at the table.  Both parties need to agree on how innovation will be defined.  I don't think companies will get anywhere if they push contract terms -- of any sort, not just innovation -- AT their service providers.  Vested Outsourcing is all about figuring out What's In It For We, and doing that TOGETHER.  And that's not just philosophy.  Our research shows that when companies work together, they will achieve more.

The innovation needs to have a foundation in business objectives.  Those objectives can be around cost, quality or competitiveness.  And they need to be baselined.  How will you measure the impact of innovation?

Once the two parties have agreed on what sort of innovations they want and the outcomes they want from those innovations, then they can build relevant terms into the contract.  You can find components of a contract strategy to drive innovation in several sections.  

These include pricing model, incentives, governance, metrics and performance, and of course legal boilerplate (think intellectual property ownership). Most important is right up front, at the top of page 1, a documented shared vision.

Be aggressive with your shared vision.  This should be more than a stretch goal.  It should be a Big Hairy Audacious Goal.  The kind of goal that makes you nervous, unsure how you’re going to achieve it.

Next most important is that you define a mechanism for rewarding the service provider for innovating.  Then, use your governance structure as a forum for developing innovations.  Make sure your weekly or monthly performance reviews, even your QBRs, spend more time dedicated to answering the question “what can we do better?” rather than “how did we do last month?”

What shared vision have you and your outsourcing partner defined for innovation?

(I’d like to acknowledge my colleague Jeanette Nyden for her assistance with this post).

 

Finding the AND in EITHER/OR

Adrian Gonzalez of Logistics Viewpoints makes some great points about getting superior results from digging out the AND in what most people consider either/or tradeoff situations.  I especially love what he says about investing in smarter, better, faster employees and how that can drive the bottom line -- unconventional wisdom in a world where stock analysts beat up CEOs when their labor costs go up relative to industry peers.

As an example of doing it right, Adrian cites my second-favorite grocery store, Trader Joe's (my first favorite is Seattle's PCC Natural Markets, because of its extensive line of organic products).  Does it make sense to you to invest in your employees?  Why?

Rocky Flats: A Vested Deal Fuels Nuclear Cleanup

Arming America’s Cold War deterrent of Mutually Assured Destruction left a legacy of nuclear waste on 10 square miles of rocky ground 15 miles from Denver.



The centerpiece of this super-secure and super-secret bomb-building complex, known as Rocky Flats, was Building 771, dubbed “the most dangerous building in the world.” Walk in there with a radioactivity sensor and you would get a new definition of “red zone.” Plutonium-fueled radiation levels were so high the building earned the nickname “the infinity room.”

Since 1953, nuclear bomb-making at Rocky Flats created contamination and waste materials whose disposal was secondary to keeping the nuclear arsenal ready.  There were many accidents and spills including the worst industrial fire in US history.  Despite the tightest security measures, word got out, and in 1989 a joint FBI/EPA raid exposed so many problems that the Department of Energy, to whom Rocky Flats reported, decided to end weapons production there in 1994.

But DOE didn’t want to just shut down Rocky Flats.  They decided to clean it up and restore it to what it was before the first bomb-making building went up:  10 square miles of prairie at the foot of the Rocky Mountains.  They eventually decided to do even better than that:  turn it into a National Wildlife Refuge.

No-one, no government, no nuclear research institute, no electrical power generating company, anywhere, had ever attempted anything so daunting.  Hundreds of observers thought DOE was, at best, over-reaching.  Trying to make the impossible possible.  The US General Accounting Office, when it examined the project, gave it a 1% chance of succeeding.

But US Energy Secretary Bill Richardson remained undaunted.  "Rocky Flats is the flagship site ... in demonstrating tangible and significant progress toward safe closure of former nuclear weapons production sites.  The safe closure of Rocky Flats by 2006 is a top priority.”

The impossible was made possible.  It took a public-private partnership that exemplifies Vested Outsourcing principles and practices to get the job done.  DOE and Kaiser-Hill (now part of CH2MHill) forged a creative enterprise to go where no human endeavor had ever gone before.  And they did it 60 years faster and $30 billion cheaper than initial estimates.

How?

The first thing they did was define the outcome they wanted:  Ten square miles of pristine prairie.  That’s the foundation for Vested Outsourcing’s Rule 1:  Create an Outcome-Based vs. Transaction-Based Business Model.  Neither DOE nor Kaiser-Hill knew, going in, how to get there, so it would have made no sense for DOE to attempt a traditional government outsourcing contract that specified every detail down to how short the grass should be cut.  As Kate Vitasek, Mike Ledyard and Karl Manrodt wrote in their recent book Vested Outsourcing: Five Rules That Will Transform Outsourcing, Kaiser-Hill and DOE had to create a Flexible Framework for a mutually-beneficial relationship governed by a win-win attitude.  This approach was embedded in contract language.  Two examples:

“Seek ways to accelerate cleanup actions and eliminate unnecessary tasks and reviews, by requiring that the Parties work together.”

“Provide the flexibility to modify the work scope and schedules, recognizing that priorities may change due to emerging information on site conditions, risks and resources.”

The contract had to focus on the WHAT, not the HOW – Vested Outsourcing’s Rule 2 – with clearly defined guardrails.  DOE and Kaiser-Hill embraced a “learn as you go” approach that they sometimes referred to as “experiment and conquer.”  The guardrails were safety, environmental and national security standards plus extensive 3^rd party scrutiny – the public, the media, local governments, watchdog organizations – not to mention operators of nuclear facilities worldwide.

Step 3 (Vested Outsourcing Rule 3) was to define the outcomes.  Secretary Richardson had defined the overarching goal of safely closing Rocky Flats.  The next level of desired outcomes was a relatively short list:

1. Collect and dispose of about 2,000 pounds of missing Plutonium
2. Securely remove radioactive waste that terrorists would love
3. Extract, transport and store huge quantities of contaminated soil, asphalt and concrete
4. Demolish and dispose of more than 800 buildings
5. Operate at the highest levels of worker safety.

Providing for flexibility, combined with clearly defined desired outcomes, led to the creation of hundreds of innovations including:

·      * Methods to treat and safely dispose of 76 toxic substances that had never before been addressed with regulations or standards.

·      * How to safely demolish buildings by carefully removing contaminated concrete from steel reinforcements designed to withstand aerial bombing attacks.

·      * A robot-operated plasma arc torch to cut up large pieces of contaminated equipment.

·      * A glycerin spray that could remove airborne Plutonium contaminants.

·      * Safety practices, now emulated around the world, that resulted in no environmental releases and no life-threatening injuries in 60 million hours of work.

The working relationship spanned 11 years.  The first contract, implemented in 1995, was a simple 5-year cost-plus contract that gave both DOE and Kaiser-Hill time to assess the challenge.  They made a dent, and the relationship worked so well and they acquired sufficient knowledge that they decided to risk what for the government was a radical approach:  A shared risk, shared reward structure that provided Kaiser-Hill with significant incentives to produce results below budget and ahead of schedule (less than 6 years).

It was a pricing model optimized for trade-up, not trade-off (Vested Outsourcing’s Rule 4) that drove the innovation.  The parties established the $3.94 billion budget together based on a cost-plus estimate.  Part of the “plus” was Kaiser-Hill’s profit and Kaiser-Hill put part of that fee at risk.  If costs ran over, Kaiser-Hill would lose some or all of the at-risk portion of its fee.  If Kaiser-Hill managed costs down, they would add a portion of those savings to their fee.

DOE’s downside risk was mitigated by Kaiser-Hill’s at-risk fee.  Costs could go 8% over budget and DOE would not go over its overall budget.  DOE’s skin in the game was a minimum fee plus an agreement that any costs attributable to DOE’s failure to provide regulatory and other forms of support wouldn’t “count.”  This provision kept DOE committed and reflected the fact that neither Kaiser-Hill nor DOE could do this project alone.  They were in it together.

The result?  Kaiser-Hill brought the project in $500 million below budget and 15 months ahead of schedule.  Actual costs were 20% below budget.  And even after Kaiser-Hill’s bonus, which resulted in an 11.6% profit margin, DOE’s total expenditure was 13% below its initial budget.

A true win-win.

It’s interesting to note that DOE’s friends at GAO – the folks who gave the project only a 1% chance of succeeding – later carped about Kaiser-Hill’s profit margin being well above the historical average rate of 4.1% on DOE projects.  Well, consider the results.

There were three other elements of the pricing model worth pointing out.  There was a second-level bonus for beating the time budget.  And to deal with typical government funding and appropriations issues, Kaiser-Hill agreed to put up the capital required to develop the innovations that drove its success – a significant risk atypical of government contracts.

And before the project began, Kaiser-Hill committed 20% of its profits to be shared with employees.  Many involved gave this provision a large portion of the credit for Kaiser-Hill’s success.  That profit-sharing commitment motivated every single employee to think about how to do things better, faster and safer.  All of those ideas, none of which could have been anticipated much less specified in a traditional cost-plus contract bound by a detailed scope of work, contributed to the hundreds of process and technical innovations that produced success.

How did they manage it all?  From the very beginning, DOE and Kaiser-Hill, from the highest levels, committed to a governance structure characterized by transparency, inclusiveness and outreach (Vested Outsourcing’s Rule 5).  This was partly a requirement based on Rocky Flats’ history of secrecy and, some would argue, deception, resulting in tremendous distrust among the local population and their elected representatives, watchdog groups and the media.  It was also essential to maintain the spirit of the collaboration.  DOE and Kaiser-Hill had to be open and tell each other the truth about everything, the good, the bad and the ugly.  They had to stay focused on the problem rather than blaming or finger-pointing when things went awry, as they will, and did, in any project of such scale and complexity.

This shoulder-to-shoulder approach was backed up by Kaiser-Hill’s project management technology, which provided the ability to dive into the details to diagnose the issues when they arose and extract the insight needed to develop good solutions.

DOE and Kaiser-Hill made the impossible possible.  They committed to each other.  They embarked on a performance-based, risk-sharing outsourcing agreement.  The flexibility and partnership they built into their agreement resulted in hundreds of innovations and widely-celebrated results.  The project won accolades around the world, including the Project Management Institute’s “Project of the Year” award and the “Project Merit Award” from the Environmental Business Journal.  The Wildlife Refuge opened in 2007.  And the experience provides a fantastic example of what can be achieved by applying the principles and practices of Vested Outsourcing.

For more information, see CH2MHill’s white paper on Rocky Flats and the project’s nomination for the Nova Award.  For a detailed view of how Kaiser-Hill attacked one of the toughest parts of the cleanup, see this description of what was known as the 903 Pad and Lip Area.  Read about DOE’s latest contract award to CH2M Hill, just two days ago, on May 4, 2011, to perform a cleanup similar to Rocky Flats at the former Oak Ridge National Laboratory in eastern Tennessee.  And, of course, visit Rocky Flats National Wildlife Refuge the next time you’re in Denver.

Jennifer the Junkyard Dog

A recent client inadvertently turned a competent manager into a classic Vested Outsourcing Junkyard Dog.  This unintended consequence of a decision to outsource facilities management services turned the set of cubicles set aside to support Jennifer (not her real name) into a hellhole of high turnover, low morale and performance well short of potential.

Jennifer led the RFP to outsource most of the functions she had managed for years.  She was highly experienced and well regarded. The contract structure was largely dictated by her company’s legal department and the framework provided by a consultant.  But it was her job to write the Scope of Work and define the Service Level Agreements.

It was that last part – writing the SOW and defining the SLAs – that wound up hurting her company more than anything.  As the in-house expert, she knew what needed to be done, how it needed to be done, and how to assess performance.  In her eagerness to get it right, she wound up with an 800-page contract with 82 sets of SLAs covering every last detail down to how often to cut the grass.  Many of the SLAs were ambiguous and subjective, but she knew what to look for.

In fairness to Jennifer, the company that won the RFP accepted that monster SOW and its 82 sets of SLAs.  It’s hard to judge that decision.  In any negotiation there are too many factors for an outside observer to assess.  But the approved contract launched Jennifer and the service provider team assigned to support her into a downward spiral.

No matter what the service provider did, it was never good enough for Jennifer.  I don’t think Jennifer deliberately took the position that the service provider could NEVER do it right.  In fact, she told me she would love to see the service provider perform well.  But let’s examine the pressures she was under and the incentives she might feel, even if not consciously.

Bottom line, if the service provider performed well, it would make her look bad.  She was the expert.  She’d managed those functions internally.  If the service provider wound up doing BETTER than she had, what would her bosses think?  And the combination of excessively detailed SOW and somewhat ambiguous SLAs left her room to always find fault.

Unable to ever get it “right,” the service provider team’s morale steadily deteriorated.  By the time I met them, nearly two years into the contract, their leaders were frustrated and miserable, performance was less than they would have liked, they were experiencing high turnover, and there seemed to be no way out.

What they needed to do was rewrite the SOW and apply Vested Outsourcing's Rule 2: focus on WHAT should be done, at the highest level possible, and not HOW; make sure SLAs were few, clearly defined, objective and measurable; and establish a jointly managed governance structure that could address any needed changes and drive process improvements.

And if we could rewind, I would have suggested transferring Jennifer to the service provider.  Then she would have had every incentive to lead her team to beat her own historical performance.

Do you have a Junkyard Dog in your world?  Please share your story.

Edward's Great Expectations

Edward fumed.  “Why can’t these guys be more innovative?  I told them when we outsourced to them, I needed them to be innovative.  But it’s just same old same old.”  Edward (not his real name) was a procurement manager for a large consumer products company.  He was visibly frustrated but hopeful that applying Vested Outsourcing practices would help.

“Tell me how your agreement is structured,” I said.

“It’s simple. We had three homegrown facilities, legacies of acquisitions.  They consolidated everything into one of their facilities.  They receive all our inbound products and components, inventory them, then fulfill orders, picking, packing and kitting.”

Edward wasn’t through venting.  “At every quarterly business review, they go through the scorecard, and everything looks great, and then I ask them about innovative practices, and they talk about some arcane improvement in materials handling systems, or something like that, but it’s nothing to write home about. And these are the people who came to me and said ‘We can revolutionize your operations, drive huge efficiencies.’  But it just looks exactly like what we were doing, only centralized.”

“Are they performing well?”

“Absolutely.  They’re very good, always hitting their metrics.”

“But you’re not getting something you want.”

“Exactly.”

“Edward,” I said, “I bet the problem lies in your contract.  I bet the reason you’re not getting innovation is that it’s not in the contract.”

“Yes it is!  Here, I’ll show you.”  And there it was, a single sentence buried dozens of pages into his MSA:  Supplier shall innovate.

“Edward, what’s your pricing model?”

“We pay them to receive.  We pay them to inventory, by the pallet.  We pay them to pick, pack and ship by the touch.”

“Do you pay them for innovation?”

Edward became flustered.  “What do you mean, do we pay them?  Of course we pay them.  The whole purpose of the contract was to get innovation!”

“Edward, I hear your frustration.  I’m going to tell you something you may not want to hear. The reason you’re not getting innovation is that you didn’t buy innovation.  You bought activities, and thereby set up a pricing structure that actually inhibits innovation.  We call it the Activity Trap.  Your supplier has no financial incentive to innovate.  In fact, it’s just the opposite.  If they innovate, it will only hurt them.”

“How will it hurt them?  It’ll hurt them if I don’t renew the contract!”

“Any innovation will mean reducing touches, or reducing inventories, or reducing some activity they’re getting paid for.  Which means they lose revenue.  When you’re asking them to innovate, you’re asking them to give up revenue.  Why would they do that?  Just like you, they’re in the business to make money.  You have great expectations, Edward, but until you revise your pricing structure based on the Vested Outsourcing principles we’ve been talking about, to make innovation financially rewarding to them, you’re going to get the same old same old.”

With that, Edward launched a contract amendment process that eventually got him what he really wanted:  continuous transformation of his distribution system.

What are your expectations?  And where are the gaps in your outsourcing agreement that cause you frustration?

Freaks in the Supply Chain

In our Vested Outsourcing work, we talk a lot about managing incentives.  We often refer to the book “Freakonomics” by Steven Levitt and Stephen Dubner.  In their work, they delight in putting the spotlight of incentive analysis onto urban myths, business lore and conventional wisdom.

Most supply chain professionals have by now had some exposure to the wonders of data analysis:  Set up your processes so you can capture the data that you can mine for insights that lead to process improvement.

We urge our clients to go beyond data analysis to explore the incentives that … drive the behaviors that generate the data that you can mine for insights that lead to process change.  We believe that becoming a “freak” about incentives will actually lead to process transformation, not just process improvement.

Consider a typical 3PL’s pick, pack and ship operation.  Most such contracts are priced by the activity.  Each pick, pack, or ship gets charged at a set price.  Enter a business owner who wants transformational change.  She asks for it at a QBR.  She sends out an email.  She brings it up in a one-on-one with her counterpart at her service provider.

She’ll promptly get transformational change, right?

What the Freaks teach us is that people and organizations respond to three types of incentives:  Economic, social and moral.  “Economic incentives” mean money.  Do this, make money.  Do that, make more money.  “Social incentives” mean peer pressure, appearances, keeping up with the Joneses.  Do this, look good to your friends.  Do that, look good to your community.  “Moral incentives” are defined by what the individual believes is right, or by the values an organization espouses.

What incentives does our 3PL have to generate transformational change?   Moral incentives?  Yep, right there in the corporate values statement:  Be an agent for transformational change for our clients.  So in that QBR, the 3PL’s managers are enthusiastic and promptly start tossing around ideas.

Social incentives?  Producing transformational change has some cachet in the 3PL world.  You can win awards for it!  So the 3PL’s executives say “You betcha” and start tossing around ideas.

And the economic incentives?  Well, let’s see.  It turns out that with an activity-based pricing model, our 3PL would actually be penalized for innovation. 

How can that be?

Because pretty much any transformational change involves taking picks, packs and ships out of the process.  If our 3PL gets paid for every pick, pack and ship, taking any of them out means giving up revenue.

Why would they want to do that?

Of course they wouldn’t.  In the world of Vested Outsourcing, if you want transformational change, an activity-based pricing structure becomes a perverse incentive because it penalizes the behavior you really, really want.  We call it the Activity Trap.

Our frustrated business owner might say, “You should do it because it’s the right thing to do.”  To our 3PL’s executives, a more important “right thing to do” is grow profits.  She might say, “You could win an award.”  To the 3PL, it might be more important to look good to their investors.

In either case, giving away revenue might not be such a good place to start.

How might our business owner and her 3PL change their pricing model to help them generate transformational change AND grow profits for both?  I look forward to your suggestions.

Dave's Desired Outcomes

A young marketing manager, newly arrived in Seattle and fresh from seven years of “basic training” at Frito-Lay, got a referral to Dave, the CEO of a fast-growing coffee company.  When our marketing manager got Dave on the phone, they chatted amiably for a couple of minutes, then Dave got down to business.

“How do you think you might be able to help me?”

The question stopped our young marketing manager in his tracks.  “I can help you with marketing strategy.  New product development.  And sales promotions.”

“I’ve got those areas pretty well covered,” Dave said.  And thus ended any potential business relationship.

Where did our young marketing manager go wrong?  He offered activities, not results.  Working on strategy, product development or promotions, those are activities.  Dave wanted results.

That young marketing manager was me.  I think about that experience whenever I get into a discussion about the first Rule of Vested Outsourcing:  "The business model must be outcome-based, not transaction- or activity-based."

If I had a “do-over” with Dave – don’t we all wish we could have a few “do-overs”? – I’d like to say something like this:

“Dave, I can drive your top line with innovative promotions, packaging and channel development strategies.  I can also drive your bottom line by applying the analytical rigor and business case development skills I learned at Frito-Lay.”

I’m pretty confident that focusing on what were probably his most important desired outcomes – growing revenue and profit margins – would have taken the conversation deeper into the realm of “how” and at least gotten me a face-to-face interview.  And once I’d satisfied Dave that I had the skills and experience that would make it likely I would succeed, we might have talked about how he might pay for me…

…bringing us into the realm of Rule 4 of Vested Outsourcing:  "Pricing model incentives are optimized for cost/service tradeoffs."  I doubt Dave would have signed up for a straight salary.  We probably would have worked out a lower-than-market base plus a bonus tied to specific revenue and profit margin goals.

A focus on desired outcomes rather than activities (Rule 1) coupled with an incentive structure that motivated my best efforts to achieve those desired outcomes (Rule 4) would have made for a mutually beneficial, rewarding and – I would bet – fun working relationship with Dave and his company.

Considering this example, how can you sharpen your definition of the desired outcomes you or your client wants from your outsourcing relationship?  And how would you design the pricing model to best deliver those outcomes?  I’d love to hear your story.