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.

From Win-Win to Win-Win-Win

In the midst of working out a win-win outsourcing deal, the two parties striking the deal can inadvertently set themselves up for problems if they forget one key person:  the end user.

Whether the end-user is internal or external, it’s the end-user’s satisfaction that will make or break the deal.  I’d go so far as to say the end-user’s satisfaction (or lack of it) will make or break the outsourcing company’s bottom line.  Making sure that end-user is satisfied means that any agreement has to provide benefits to all three parties.  So if you’re not going for win-win-win, you will lose-lose-lose.

And if the company’s ability to satisfy end-users doesn’t improve over time (and relative to competition), the suffering will grow exponentially.

Many outsourcing agreements fail.  I see a variety of reasons for this, usually boiling down to rushing the deal, sucking the life out of the vendor or outsourcing for the wrong reasons:

·      Rushing through planning and transition kills performance.

·      An all-too-frequent pattern of beating up vendors on price blocks investments in transformational process change and service improvements.

·      Outsourcing for any reason other than getting better at what you do as a combined entity will undermine the project’s effectiveness (think balance sheet moves).

Without continuous improvement in performance for the end-user, the company enters a downward spiral toward its eventual death.

Focusing on the end-user breaks that pattern.  An agreement built around measurable benefits to the end-user creates a framework for working together.  When the company and the service provider work together, they become vested in each others’ success.  Neither can accomplish alone what the combined entity can produce.  Cost never stops being a factor, but cost decisions get made in the context of external performance measures – based on the preferences of end-users – and mindful of the many alternatives end-users have to buy similar products or services from others (think market share). 

So if you’re having problems with your outsourcing agreements, bring the end-user back to the table.  Make sure the agreement rewards all three parties and “vests” the company and the supplier in each others’ success.  Collaboration will assure maximum benefits to all involved.

A true win-win is a three-way win:  one for the company outsourcing, one for the supplier, and one for the customer.  After all – isn’t the customer why everyone is in business?  Let me know what you think.