Any Vested relationship flourishes best in a culture in which participants work together to ensure their mutual success. In essence, Vested buys desired outcomes, not individual transactions. The service provider is paid based on its ability to achieve the mutually agreed desired outcomes.
Success in Vested requires engagement of five rules. Here we examine the fourth of those five rules: Optimize pricing model incentives for cost/service trade-offs.
The fourth hallmark of a Vested partnership is a properly structured price model that incorporates incentives for the best cost and service trade-off. A logical pricing structure is essential to avoid ailment No. 1, the “penny wise and pound foolish” syndrome described in Blog No. 1. The pricing model is based on the type of contract — fixed price or cost reimbursement — that will be used to reward the outsource provider.
When establishing the pricing model, businesses should apply two principles:
- The pricing model must balance risk and reward for the organizations. The agreement should be structured to ensure that the outsource provider assumes risk only for decisions within its control. For example, a transportation service provider never should be penalized for the rising costs of fuel, and a property management service provider never should be penalized for an increase in energy prices.
- The agreement should specify that the service provider will deliver solutions, not just activities. When properly constructed, Vested will provide incentives to the service provider to solve the customer’s problems. The better the service provider is at solving those problems, the more profits the outsourcing company can make. This solutions-oriented approach encourages outsource providers to develop and institute innovative and cost-effective methods of performing work to drive down total cost while maintaining or improving service. The essence of Vested is a strategic bet by the outsource provider that it will meet the service levels at the set price. Inherent in the business model is a reward for the service provider to make investments in process, service or associated product that will generate returns in excess of contract requirements. Performance partnerships usually are based on fulfillment of the desired trade-off stated by achieving:
- higher service levels at the same cost
- the same service levels at lower costs
- higher service levels and lower cost levels
If the service provider does a good job, it will reap the rewards of greater profitability.
Vested does not guarantee higher profits for service providers; it does, however, provide them with the authority and autonomy to make strategic investments in their processes and product reliability that can generate a return on investment that is greater than a conventional cost-plus or fixed-price-per-transaction contract might yield. Vested also typically seeks to encourage service providers to meet the desired performance levels at a flat or decreasing cost over time. Therefore, the service provider has to leverage its unique skills and capabilities to make the processes more efficient — to the point that it can generate increased profit. By doing so, the outsource provider may earn intangible benefits, such as contract extensions, additional business or locations, expanded services it can offer the partner, or the willingness of the customer to provide references.
Partners in a Vested relationship — the originating company as well as its vendors — should continually seek ways in which to reduce the total cost of the process being outsourced. The interwoven dependencies of outsourcing relationships require an environment that encourages service providers to push outsourcing companies to change internal processes if they are inhibiting the success of Vested. Outsourcing companies also must be open-minded and accountable for driving internal process changes.
The correct pricing model supports the business and provides appropriate embedded incentives. It is important to understand implicitly that the outsource provider is a profit maximizer. This is reasonable, since few businesses are designed to be otherwise. Therefore, companies that outsource contracts to vendors should explore means of encouraging top performance by vendors of outsourcing services, and should reward that performance financially.
Is this approach a risky bet for a company and its service providers? Most thought leaders say no. The profitability potential exceeds possible liabilities. Adrian Gonzalez from ARC Advisory Group, which specializes in supply chain management and third-party logistics, offers this advice: “What differentiates Vested [is] not the risks, which are inherent in any outsourcing relationship, but the potential payoff for both service providers and customers. In other words, the benefits-to-risk ratio is much greater for Vested. And the risk of remaining at the status quo — in terms of lower profits for service providers and continued diminishing returns for customers — trumps them all.”
Organizations can encounter difficulty in attempting to build a dynamic relationship that challenges the status quo in existing processes. But properly structured Vested partnerships can — and do — create paybacks for both parties.
Following Vested Rule #4 prevents the Penny Wise and Pound Foolish and Sandbagging ailments.
Read More! Move on to Rule# 5 Governance Structure Should Provide Insight, not Merely Oversight