No matter why a firm outsources, almost all have room for improvement. Outsourcing deals have often been structured with fundamental flaws in the business model and the relationship. The flaws result in either direct negative behaviors or unconscious behaviors that drive unintended consequences. These inherent flaws are analogous to toxins that cause disease or illness. These flaws in how companies structure agreements lead to what is known as “perverse incentives.” Perverse incentives have unintended and undesirable effects that go against the interest of those who established the incentive. Perverse incentives by definition produce negative unintended consequences.
A classic example is from Hanoi when a French program paid people a bounty for each rat pelt handed in. The program was intended to exterminate rats. Instead, people began the farming of rats to collect the bounty.
How does the concept of perverse incentives relate to outsourcing relationships? Our research has exposed 10 of the most common issues we often refer to as diseases that sicken an outsourcing relationship. In some cases, the disease can simply cause negative side effects. In these cases, companies or outsource providers often battle the effects on a daily basis, and simply learn how to live with it. In other cases, the disease goes hidden deeply within the relationship — and neither the provider nor the user may know they have the disease. In the worst cases, the disease is so severe that it eventually causes the death of the relationship, which causes the company to either bring the outsourced services back in house or switch vendors.
The first step to improve the health of your outsourcing relationship is to get the proper diagnosis. Unfortunately many organizations that are involved in outsourcing relationship don't always know they have a problem. This article outlines the first 3 of 10 of the most frequent flaws of outsourcing business models that lead to perverse incentives.
Penny Wise and Pound Foolish
Too many companies profess to have an outsource “partnership” but behind the scenes they focus solely on beating up their service providers on price. The danger in focusing on the cheapest offer is like anything else — you make tradeoffs in quality and/or service.
In one extreme example we witnessed a company re-bid their transportation services every three months. In this case, the company had churned through virtually all of the top 20 suppliers over the course of a 5-year period and were now forced to work with suppliers of lesser quality.
Another company (referred to by their suppliers as the “800 Pound Gorilla”) decided to outsource all of the manufacturing to allow them to focus on their core competencies. They went through several rounds of extreme negotiations to save the last possible dime on a book of business worth roughly $100 million. They awarded the work to a $1 billion outsource provider. The problem? The outsource provider “bought” the business, and eventually could not sustain the losses of handling the account. They gave the 800 Pound Gorilla a 30-day notice they would not longer manufacture their products and eventually went into bankruptcy — tanking what was once a successful and profitable $1 billion firm.
Organizations that have this disease are the ones that give outsourcing a bad name-and should not be outsourcing in the first place. Their myopic focus might have good short term payoffs, but this approach has proved time and again it does not pay to be Penny Wise and Pound Foolish.
The Outsourcing Paradox
Another trap that many companies fall into is developing the “perfect” set of tasks, frequencies and measures. The “experts” within the company attempt to develop the “perfect” Statement of Work. The result is an impressive document containing all the possible details on how the work is to be done. However, this “perfect system” is often the first reason that the company will fail in its outsourcing effort. That's because it's the company's perfect system, not one designed by the provider of the services.
During a site visit to a 3PL that provides warehousing for spare parts, we saw approximately eight people servicing a facility that on average had less than 75 orders for spare parts per day. When asked why they had all these resources for so little activity, the manager responded, “that is what the client company requires per our statement of work — so I have staffing at that level to meet the contract requirements”.
We are continually amazed to find that companies have chosen to outsource to the “experts” yet they define the requirements and scope of work so tightly the outsource provider winds up executing the same old inefficient processes.
The Activity Trap
Traditionally, companies that purchase outsourced services use a transaction-based model where the service provider is paid for every transaction — regardless of whether or not it is needed. There is simply no incentive for the outsource provider to reduce the number of non-value-added transactions because a reduction of transactions would translate to a reduction of revenue. Even if the outsource provider's profit is a fixed profit level, the typical outsource provider will be penalized for investing in process efficiencies to drive costs down.
Perverse incentives also creep in. 19th Century paleontologists traveling to China used to pay peasants for each fragment of dinosaur bone (dinosaur fossils) that they produced. They later discovered that peasants dug up the bones and then smashed them into multiple pieces to maximize their payments.
On one recent site visit, we asked the General Manager of a 3PL what the large area full of “orange tagged” pallets was for. She replied, “That's some of our customer's old inventory I need to move to an outside storage facility.” When we dug further we found out it was product that was well over five years old. At the rate it was moving, it would last 123 years. We asked why they didn't work with the customer to scrap the material. The response was “Why? I charge $18 per pallet per month to store it. I'd lose revenue if I did that!”
The next example comes from IT/Sales Support. A large technology company was transferring sales support activities from one outsourced provider to another. They found that the data required to run certain reports was no longer current, and the new data was being stored in a new format in a different location. This had not been made known to the current provider, so the reports that they had produced for the past five months were, in fact, wrong. In a damage control drill, the team also learned good news and bad news — the sales manager who had requested this had been transferred, and the new sales manager did not use this (now inaccurate) report. But it was still a required activity, and the outsourcing company was being charged each month to generate the report.
The third example comes from outsourced manufacturing. The particular contract manufacturer performed final kitting and assembly “pack-out” as a value added service for their customer. The customer had given the contract manufacturer the Bill of Materials with detailed instructions to use a specified finished goods “pretty box” for the product. Each “kit” had multiple parts organized in a box. The contractor needed to assemble the box and then insert the parts in an organized manner. To build the box required the contractor to have 12 “touches” for which the 3PL charged a flat fee per touch to assemble the box carton and 1 “touch” for each item placed in the kit. The contract manufacturer knew that the particular box design was not efficient, but simply did what they were told rather than proactively offering solutions for an improved box design, which could eliminate touches.
The Rise of PBO
With a better appreciation for a few of the typical diseases that plague outsourcing relationships, you are likely to ask yourself “Is there a better way?” The good news is that thought leading companies have been challenging traditional outsourcing models for over 10 years. The result has been an evolution to a “next generation” outsourcing model we call Performance-Based Outsourcing (PBO).
The heart of the PBO is the agreement on what we term “desired outcomes”. Desired outcomes explicitly state the results on which both companies will base their outsource contract. A PBO partnership clearly defines financial penalties or rewards for not meeting or exceeding agreed upon, desired outcomes. In a PBO agreement, regardless of what is being outsourced, the outsourcing partner has the ability to earn additional financial value (e.g. more profit) by contractually committing to achieve the desired outcomes. Simply stated — if the outsource provider achieves the desired outcomes (achieves results), it receives a bonus. Note that it is important to understand that PBO is NOT gainsharing.
The Mind Shift Change of PBO
It's important to digest that PBO is much more than doing an activity at a higher level of service. For example, it is:
NOT about achieving 99% fill rate for your warehouse provider vs. 95%
NOT about answering 95% of all calls in 20 seconds versus 30 seconds
NOT about achieving quality defects from 3000 DPPM to 3.4 (six sigma) DPPMs from your contract manufacturer
NOT about ensuring that janitorial service providers clean the toilets every 2 hours
…and the list can go on and on.
PBO is a fundamental business model paradigm shift in how the company that is outsourcing and the service providers do business. Unfortunately, many people on both sides of an outsourcing relationship simply do not understand the fundamental business model concepts behind PBO. A common mistake occurs when an organization thinks they have a PBO because they have taken their existing contract and simply added that if service provider achieves the metrics they are paid a bonus. This completely misses the mark. PBO is a fundamental business model paradigm shift in how the outsourcing company and the service providers do business.
The University of Tennessee and the authors believe that PBO is a powerful strategy. We also feel that any company wanting to improve their relationships should be able to have a sound guidebook for helping them and have therefore published this free book on their findings, available at http://PROResources.utk.edu
The University has also launched a new class titled Performance-Based Outsourcing: Buying Results, Not Activities! offered as a three-day open enrollment class at the University of Tennessee's Center for Executive Education. (http://thecenter.utk.edu/cms/Performance-Based+Outsourcing+%3A+Buying+Results+/43.html)