The Imp of the Perverse in Outsourcing

The old saying, “If I didn’t have bad luck, I wouldn’t have any luck at all,” could easily apply to outsourcing incentives: If there weren’t any perverse incentives in a contract, there likely wouldn’t be any incentives at all!

Incentives play a critical role in in Vested Outsourcing, namely in identifying and achieving the win-win and in encouraging continuous innovation and collaboration. It creates conditions for an incentive mindset and ecosystem, but equally as important, the Vested Outsourcing approach will identify and eliminate those impish perverse incentives.

In a conventional transaction-based outsourcing environment, the emphasis is on conforming to contract requirements and adhering to contract terms. Little incentive, leeway, or opportunity is offered for service providers to explore innovative approaches.

In fact, in many cases, there are significant disincentives to innovation and creativity, many resulting in what I call Ailment #3, the Activity Trap. If pay rates are based on each transaction, it follows that the more transactions that are performed, the more money a company will make, whether the transactions are necessary, or whether there is a more efficient way to do them. There’s no incentive for the outsource provider to reduce the number of non–value-added transactions, because such a reduction would result in lower revenue.

The Activity Trap can appear in a variety of transaction-based outsource arrangements. When the contract structure is cost reimbursement, for example, the outsource provider has no incentive to reduce costs because profit is typically a percentage of direct costs. Even if the outsource provider’s profit is a fixed amount, the typical company will be penalized for investing in process efficiencies to drive costs down. In a nutshell, the more inefficient the entire support process, the more money the service provider can make. Inherent in the activity trap is a disincentive to try to reduce the number transactions, and conversely – or perversely – increase them if at all possible.

A good early example of a perverse incentive based on transactions occurred in the nineteenth-century, when paleontologists traveling to China would 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 to maximize their payments.

Fast forward to the present: On a site visit, when we asked the general manager of a 3PL what a 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 and at the rate it was moving, it would be in storage for 123 years! When we pressed further, asking why she did not work with the customer to scrap the material, the answer was: “Why? I charge $18 a pallet per month to store it. I’d lose revenue if I did that!”

Too often the emphasis is on knee-jerk compliance, not continuous improvement or innovation. Service providers that try to introduce new ideas may encounter significant obstacles, requiring complex, costly, and often painful contract modifications.

A properly structured vested agreement based on the Five Rules will take the luck – good or bad – out of incentives.

Under Rule 4 pricing model incentives for cost and service trade-offs will be optimized early-on by all of the parties, while Rule 5 says that a proper agreement governance structure will provide insight on the relationship, not merely oversight. Insight will detect and quickly counter perverse incentives and make sure the pricing model incentives are functioning properly.

Most important in avoiding the propensity for perverse incentives is Rule 1: Focus on outcomes, not transactions.

Don’t let the bean-counter mentality take over.

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