“It’s odd that you can get so anesthetized by your own pain or your own problem that you don’t quite fully share the hell of someone close to you.” — Lady Bird Johnson

If a pound of carrots doesn’t drive outsourcing vendor performance, maybe a little pain will? Read on to learn how to structure service level credits to incent vendor performance.

Many services, outsourcing, and vendor management programs are governed by service level metrics and key performance indicators. When the vendor fails to meet established standards, they are financially penalized. This is a form of liquidated damages.

With little doubt, penalties in small quantities, as well as the threat of greater financial impacts, drive vendor performance. While not every vendor will be enterprising enough to strive for incentives, no vendor likes to forgoe margin. However, nickel and diming a vendor wont get attention. A structured performance management program will squarely drive root cause analysis and performance improvement, but a significantly sized penalty catches the attention of vendor account management executives and CFOs.

It is important to establish this structure in your contract before or during negotiations, as seeking penalties without a contractual framework is next to impossible. This part of negotiations is significantly difficult to resolve because questions of fairness, profitability, and integrity are frequently discussed.

Without any doubt, vendors price risk into their contracts. No vendor expects to achieve 100% of all service levels on a regular basis, thus they pad their profit margins to accommodate some performance issues. The most sophisticated vendors run probability models to determine likely impacts to their profitability, and they price this into their model. This is why vendors frequently ask clients for historic performance over the last 6-24 months. It helps them understand how much they must pad their margins (in addition to understanding the severity of the measurements or the desperation of the client to find a higher performing solution). Sharing this information can be hurtful and helpful - use judgment when considering the release of performance data.

Service level penalty/credit structures typically have the following key characteristics:

• Capped Risk - Unlimited risk is difficult for anyone to handle, so vendors will principally focus on capping the maximum payout for poor performance. The numbers range from 2% to 200% of weekly, monthly, quarterly, or annual invoice amounts. While it’s fair to exempt certain fees from being included in the invoice amounts (for example, travel expenses), almost everything else should be included as the fees are all supposedly tied to the performance of the vendor.
• Weighted Metrics - Undoubtedly, clients have a certain number of metrics they want measured. Since they have different values to the client, the client weights the metrics differently. This can be done by allocating a fixed number of points across the metrics or simply identifying different penalty amounts for each metric which reflects the metric’s importance. Clients who have too many metrics will find the penalties to be too small. A good number is between two and six. Remember to avoid “double jeopardy” situations where failure to achieve one metric causes other metrics to not be met (except in catastrophic situations).
• Accelerators for Significantly Poor Performance - In a black and white world, performance either meets or fails to meet expectations. However, a vendor who misses the goal by .01% versus 75% should be impacted differently. In addition, a vendor who consistently misses the same goal, should feel the pain level ratchet-up. Vendors will often offer termination for breach, but most companies aren’t going to terminate, as the switching costs are too high. As a result, clients need to include mechanisms that multiply the penalties until the problem is resolved.
• Excused Non-Performance - The vendor isn’t always at fault for failure to meet expectations. Either figure a way to carve the work impacted by a company or uncontrollable event out of the calculation or allow the vendor to be excused from a portion or the entire metric.
• Date When Penalties Go into Effect - Establish an effective date for each metric to ensure the vendor knows when the penalties will go into effect. Potentially ratchet them up to full strength over a period of time to ensure smooth implementations. Remember, a classic move by a vendor in the middle of implementation/transition is to ask for a delay in this effective date to accommodate learning curves. Generally, do not provide forgiveness, but a good alternative if the reason for the delay is not solely the vendor’s problem is to offer an earn back if the vendor achieves the performance metric one or two months late.
• A Framework for Change - As operations often change, as do their leaders, its important that clients reserve the right to change metrics as needed. Vendors would love to force this through change control, as it gives them a second opportunity to negotiate down the penalties. Good contracts allow clients flexibility to add and delete metrics, as well as change their relative weighting.

Lastly, one of the most important issues clients need to realize is that there have been many, many bad clients who swindle vendors into agreeing to performance metrics that the vendors could never reasonable achieve. These unscrupulous clients use service credits to receive discounts on the services. This is not fair and you should never permit this to occur - it destroys the foundation of a good client-vendor relationship.

Do you use other other methods of managing service level penalties or credits? Leave a comment!

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Do you wonder if contractual performance incentives work? These are the “bonuses” vendors get for exceeding service level agreement (SLA) performance targets or achieving certain milestones earlier than expected.

We do, too. Take the poll survey, view the results, and read our nine suggestions on how to make the best use of contract incentives.

Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.

There is a tremendous amount of academic and business research on economic incentives. Most of the academic research pertains to controlled environments too dissimilar to normal business situations to be applicable. The business research is non-conclusive and the authors lack sufficient objectivity. Therefore, you’re treading into generally foreign waters.

When you are considering incentives, keep a few concepts in mind:

1. Don’t offer incentives for “showing up”. Incentives should be offered for significant performance achievements. If the vendor has offered to do xyz, actually doing xyz shouldn’t earn an incentive. In fact, failure to do xyz should result in a penalty.
2. Understand the economics of the metrics. Incentives frequently do not make sense to offer. For example, a call center frequently tracks abandonment rates. Reducing abandonment rates frequently requires different workforce management ratios. The cost of these ratios frequently exceed the value of the incentive - so the vendor isn’t driven to achieve this incentive.
3. Use clear language. Just as with any metric, KPI, or transformational goal (we’ve authored articles on all three areas), clearly define the threshold and payment calculations. Check out the “$1 Million Comma” for an example of poor contract drafting.
4. Cap your exposure. Never, ever offer unlimited or undefined maximum payments to vendors. If there are multiple incentives, cap the aggregate at risk amount you have.
5. Use graduated incentives. Don’t offer a 5% incentive for exceeding normal performance by .01%. Offer gradually greater incentives for gradually better performance.
6. Consider penalty/credit earnbacks as an alternative to incentives. For example, consider a weighted yearly average of monthly performance metrics and be willing to credit a certain percentage of those credits if yearly performance exceeds certain targets.
7. Don’t offer incentives that drive perverse behaviors. Providing an incentive to a vendor to achieve a certain productivity goal may result in lower quality results. Consider using double barreled incentives to eliminate this from occurring.
8. Consider the magnitude of incentives. If a vendor expects a regular 10% profit margin on services and the cost of achieving an incentive is negligible, but it provides a 5% bonus on gross revenue, you’ve increased profit margins by 50%!
9. Track incentive payments. Use this information to understand the true cost of performance and to negotiate lower rates for same performance at contract renewal points.

If you have additional thoughts, share it with the ever growing readership of 360° Vendor Management by leaving a comment.

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One year from today, March 31, 2009, the Software Technology Parks of India tax scheme will sunset. When this happens, Indian companies will find their taxes increased from 10% to 20%. Depending on your specific contract terms addressing taxes, material changes, or other sections (talk with your legal team), vendor managers may be confronted with higher rates. What can you do to manage this?

First, some background information. STPI was created in 1991 to create tax incentives to stimulate India’s then-fledgling software export industry. It provides a combination of incentives, but the big incentive is the 10-year corporate tax exception granted to new organizations (Indian companies consistently create new organizations to restart the 10-year clock). Today, 95% of India’s software and BPO exports are subjective to this incentive. Exports are the services you are buying if you or one of your vendors outsourced work to a foreign country. Indian companies have been unsuccessfully lobbying the Indian government to extend STPI, but one never knows.

Whether it is next year or further in the future, the Indian government, given the social pressures of the country’s government faces, is clearly looking to cash-in on the enormous industry. This year, they introduces a Minimum Alternate Tax. They have also established Special Economic Zones (SEZs) that will will give tax incentives for fifteen years (100%, 50%, and up to 50% exceptions for each consecutive five year period). However, not ever Indian company operates in a SEZ, and it is unlikely will when STPI expires.

“If” is not the question, but “when” is. When it does, one thing is sure: the Indian outsourcing industry’s tax burdens will increase and they will undoubtedly look for you to pick-up the bill. More to the point, almost every country with significant ITO and BPO industries have similar tax incentive programs, and these governments will be carefully watching how India’s mature industry is monetized.

Here’s what you can do to mitigate your risk:

• Get more knowledgeable on this subject now. Talk with your attorneys, analysts and consultants. Do not wait for your vendor to “educate” you. There are many layers of taxes and your advisors will be able to separate hearsay from fact.
• Negotiate your pricing terms to reduce your exposure to changes in Indian taxes.
• Use the risk as another reason to diversify your offshore vendors and locations. Multi-location, multi-vendor strategies mitigate a wide variety of risks.
• Recognize that this change will not kill the Indian industry - it will just level the comparative costs among countries. India will likely become just as expensive as the Philippines.
• Adjust your financial plans now as you enter into 2009 budgeting and planning.

Other ideas? Other information about STPI or other incentives? Please share it by posting a comment!

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“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” — Adam Smith, The Wealth of Nations, 1776

We find ourselves in uncertain times caused by globalism and the talk of self-preservation.  Where the Western world once sat behind the wheel, driving technology and automation into our businesses and personal lives, poorer countries are now poised to operate, maintain, and improve the technology the West created.  Adam Smith’s great “Invisible Handle” metaphor contains a balancing paradox.  The West’s businesspeople moved factories and service operations to foreign countries to take advantage of low wages.  These wages improved, creating new economies in once poor countries.  Over time, an equilibrium will be found and will persist until new entrepreneurs drive innovation, which will again make certain countries mighty until these innovations are outsourced or imported to other countries for the poor countries’ benefit.

And so the seesaw rocks back and forth.

One of the great frustrations of those who see the pattern of globalization is the extent to which the normal, non-entrepreneurs will go to protect their world from change.  Like a great freighter’s anchor, the protectionists will dig deep to prevent natural change rather than hoisting anchor and going with the natural flow.  The natural flow is unstoppable, because unnatural barriers to change will cause catastrophic disasters.

Your only choice is preservation of self-interest - to become rich and wealthy through innovation.

In the outsourcing world, which started in manufacturing, moved to information technology, and now is squarely focused on services, the challenge is innovation.  Driven by economic pressures, more often than not, a company outsources XYZ and takes the entire savings to the bottom line.  The savings is just temporary, as the labor arbitrage or a vendor contract negotiation will find equilibrium again.  Consequently, outsourcing critics speak truthfully about the impact of outsourcing to local jobs, although most see only the short term impact.

A company that outsources and does not invest in innovation or transformation misses the great value of that could be created by infusing the freed capital back into its operations.  The long term impact of the failure to innovate is devastating because competition will, eventually, find balance again.

The problem with outsourcing critics is that the laws they seek to enact are noting more than the proverbial finger in a dam’s leak.  Eventually, innovation will be exported and the competitive equilibrium will bypass the very communities the critics wish to preserve.  Halting globalism is simply impossible.

The critics need to focus on innovation, not preservation.  Thomas Friedman’s “The World is Flat” was not so astounding for its exposure of the extent of outsourcing.  Rather, the exclamation point of Friedman’s book was the last few chapters that explained the souring of Western education, the very fuel of innovation.

Companies who take outsourcing savings to the bottom line are no less at fault than our governments and societies.  Companies that outsource and do not gain great competitive advantages through their partnerships also are at fault.   Communities and politicians who expect protectionist measures to work are at fault, too.

In this global environment, the winners are those who realize their self-interest is tied to creation, not preservation.

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Jamaican hurricanes, Costa Rican volcanoes, Philippine political coups, Indian taxi strikes, Chinese government-operated firewalls, Canadian blizzards, and the legendary American backhoe operating behind your data center are dangers to your business when you outsource to offshore locations.

Realistically speaking, geologic, social, political and weather-related disasters his every city of every country. Granted, some events are more or less likely in certain locations, but the unexpected can strike you when you least expect it. What would you do? Do you have a business continuity plan or a disaster recovery plan?

Here’s a place to start:

• Consider the Impact, not the Event - Generally speaking there are four types of impacts that you need to plan for: loss of people, loss of facilities/building, loss of connectivity, and loss of applications. Any given event can cause one or more of these impacts. For example, a political coup could cause your operations team to have insufficient quantities of personnel (loss of people) and loss of connectivity (if the telecommunications company shuts down). Plan for the impacts, not the disaster.
• Consider Time Frame of Impact - An impact can last 5 minutes, 50 minutes, 5 days, 5 months, or be permanent. When an event creates an impact, your plan should provide clear direction based on the expected duration of the impact.
• Have Clear Procedures - A plan that says “open new center in a hotel conference room” is insufficiently detailed. The plan should have clear procedures for retraining, relocating personnel, reconnecting systems, and procuring goods/services necessary to recover. For example, relocation of personnel should have a clear plan for sources of transportation, roadmaps with specific routes to take, and temporary housing.
• Plan for Staged Recovery - Few serious impacts can be instantaneously resolved. For example, telecommunications circuits are generally recovered one at a time. People will return to work slowly.
• Consider Side Effects - A major weather disaster is typically followed by disease. So, while a hurricane is unlikely to cause a loss of people, the cholera, stomach diseases, or other health concerns could.

Finally, test your plan at least once per year by first calling a pre-planned meeting and role-playing resolution and actions. Later, call an emergency meeting when leaders are not prepared. Take notes on the actions (do not critique in the middle - let the disaster and recovery unfold). Afterwards, analyze the actions and provide feedback. Expect your business continuity and disaster recovery plans to improve each time your rehearse. Also, expect your business leaders and vendors to get better each time. Hopefully, the practice will pay off when the next emergency occurs.

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Picture this: Your company has outsourced customer service for some products, but not all products.  You have a single vendor with over 1,000 seats dedicated to your operation.  These seats are located in several centers located in the USA (for reasons not important to this story).

Your vendor management team is made-up of a single person.  This person coordinates five different programs, handles contractual issues, reviews invoices, schedules training, manages quality, and sets the direction of the five programs.  Needless to say, this person is very busy and, quite honestly, overwhelmed.  No single person could perform this job.

One day, an internal customer service group who did not outsource their operations planned a team lunch to celebrate February birthdays.  However, 12pm-1pm is also the time when customer service team receives the highest call volumes.  As the team all wanted to celebrate together, they needed someone to cover the phones while they ate cake and ice cream.  Driven by hunger or the love of a celebration, the team made a fatal decision.

A few minutes before noon, after the cake and ice cream were set-up in a nearby conference room, the team’s workforce manager flipped a switch that redirected the calls to the vendor.  The phones went silent and the team rushed into conference room.  They sang happy birthday so loudly that other people in the building could hear them. They took the time to also observed a company tradition of sharing what they liked about each of their February birthday team members.  It was a great party.

Meanwhile, someplace else in the country, the vendors’ call center was completely inundated.  Service levels fell to 4%, abandonment reach 85%, and the workforce team was struggling to understand the reason for the high call volumes.  Worse yet, these weren’t their calls.  They had no training on these calls.  So, following standard procedure, once they recognized that a caller was in the wrong queue, the vendor’s agents would cold transfer the call into the right queue…which promptly routed the call back into the vendor’s queue.  Customers were irate.  The team director tried to call the vendor manager, but the vendor manager was in meetings and was unreachable.

Back at the client’s center, the happy agents returned to their desks and once everyone was ready, the workforce manager flipped the switch back.

Do you have a story to tell about vendor management gone bad?  Let us know.

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Most of the concerns surround security, which raises these questions: Does the place of manufacture create more or less security than how it is managed?  How do you ensure your company and customers’ information is secure?

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XYZ has two call center programs.  One is a major inbound customer service program and the other is a small (about 45 agents) complex inbound/outbound marketing programs that focus on driving customer loyalty and create a significant revenue lift.

XYZ’s marketing and customer service organizations feud regularly about vendor management.  Customer service insists on “owning” the vendor relationships and requires the marketing organization to liaise with the vendors through customer service’s vendor management team, which was insufficiently staffed and generally lacks vendor management experience.  This inadequacy led the marketing team to circumvent the customer service vendor management team and they began to manage the vendors directly.  The vendor management team became irate and the resulting seething rift between the two organizations was/is palpable.

Then came Christmas, the busiest 60 days of the year for XYZ.  The customer service vendor management team made a significant forecasting error and found themselves delivering a 3% service level over several weeks.  Yes, that meant that they answered 3% of calls in 45 seconds, which is terrible.  XYZ is a major company.  This was a nightmare.

Meanwhile, the marketing program was hitting on all cylinders.  It was creating a record ROI and the vendor and the vendor agents were ecstatic.  Attrition was a minuscule 10% annually.

This is when things got personal.  Jealous by the success of the marketing program, the customer service team ordered the vendor to immediately put all of the marketing program’s’ agents in the customer service queues.  They didn’t notify the marketing program.

We should point out for those less knowledgeable on the subject that a program that has thousands of seats is not going to create a meaningful lift in service level by adding a mere 45 agents.  This decision was almost entirely political, and was also poorly calculated.
In this case, XYZ sacrificed a successful marketing program and gained nothing, as all but 9 of the agents left within two weeks of joining the customer service queues.  Furthermore, XYZ squandered the returns they were creating in the marketing program - about $1M.

Funnier yet, the marketing program didn’t notice that their program had stopped until one week later…their success had less to do with their own vendor management capabilities than the vendor’s awesome execution.  Dumb luck?

Can’t we all get along?

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• Terminating an Outsourcing Relationship
• International Trade Concerns

Phil has just published a research paper on Ten Things to Look for in an Outsourcing Advisor.  There’s also a couple of long threads on Phil’s blog on this topic.

Also, Vinnie provides some insights on at Deal Architect.

Oh, and Phil, check out the usage rules around “Adviser” versus “Advisor“.  A UK vs USA rhetorical feud won by the Brits finally?

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Despite the never-ending flow of positives clients, vendors, advisory firms, and the Philippine government use to describe the Philippine outsourcing market, the present day reality is much different.  The Philippines actually poses a significant future risk to your operations.  Here’s why:

• Workforce Attrition - Less than 3-4 years ago, more than one well-known CEO in India explained to us, “There is an unlimited labor pool.  Wages will never increase.”  Well, that certainly wasn’t true.  Vendors and captives also exploited low wages by bidding-up labor markets in a savage back and forth talent war.  Many companies sought shelter in Tier 2 cities, but the peaceful period was brief, and companies turned for shelter in Tier 3 cities - where the same fate ha occurred.  The Philippines are experiencing the exact same phenomenon.  In fact, one CEO even recently pitched opening a center in the Southern islands, which is a place no company should consider, unless tapping into Tier 2 cities along the Indian-Pakistan border or Pakistan-Afghanistan appeals to you.
• Complex Services Meet Inexperience - One aspect of BPO that differs from ITO is that there is no education program to develop call center and backoffice outsourcing operations leaders.  Consequently, there are insufficient quantities of talented middle management in the Philippines.  Now that most companies have outsourced a little “easy stuff”, they are  outsourcing significant amounts of simple work, more complex work, as well as acquiring transformational services.  The management challenge is huge.  Where a call center used to get by on relatively easy workforce management planning, large operations demand sophisticated WFM skills.  These skills are incredibly hard to find in the Philippines, unless you import them or buy them from other vendors/captives (see the attrition issue above).
• Political Uncertainty - One of the great underestimated aspects of the Philippine political scene is its complete uncertainty.  You’ve probably already read the annually updated US State Department Travel Advisory.  However, take a moment to review all the other countries with similar warnings.  Pundits will argue that 1) the problem is in the south and 2) no government would stop the expansion of the outsourcing industry.  We generally agree, with two major caveats.  First, it takes but one election to ruin a country’s future.  Second, if the Philippines become an unsafe destination for business men to visit or for long term deployment of vendor management personnel, outcomes become difficult to manage.
• Currency - Currency instability is challenging in the Philippines.  While Indian companies took significant steps to hedge their currency, most operations in the Philippines are owned by foreign companies.  These companies don’t hedge, so they pass their costs onto you.

Essentially, the Philippines of today is the India of 3-4 years ago.  There is no reason to expect a different outcome.

However, while there are challenges, sophisticated vendor managers can mitigate every one of these challenges if they focus on strategic, long term issues that accompany outsourcing efforts.  Vendor managers who focus solely on day-to-day issues will run into profound problems if they don’t diversify locations, manage financial currency risk, or seek creative ways of bridging the middle management talent gap.  If managed effectively, the promise of the Philippines is definitely positive.

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Related Posts

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• In the Absence of Outsoucing Governance or Vendor Management
• Poll: How did you learn to be an effective vendor manager?
• Vendor Managers Can Satisfy Internal Stakeholders
• An Outsourcing Vendor’s Business Continuity and Disaster Recovery Plan
• Managing an Outsourcing Vendor’s Financial Instability
• Good Vendor Managers: A Scarce Commodity