Read the small print - contracts and incentive mechanisms

A recent post on this blog looked at how lessons analysis can help organisations identify some of the high-impact issues affecting their performance.  Yesterday we examined ‘interface management and communication’ and discussed how some companies suffer blockages in the flow of knowledge and information throughout their organisation and beyond.

We now turn to the related issue of contracts and incentive mechanisms.

What is the problem? 

Most organisations recognise the need to take time when negotiating contracts and will often pay significant sums of money for expert oversight and advice in this area.  However, when time is short, clauses or their precise meaning (as intended by the drafter) can be missed. This can expose both clients and their ‘contractors’ to unforeseen risk regardless of the contract type.

Two common types are the fixed or ‘lump’ sum contract for a defined scope of work or a ‘reimbursable’ one where a daily rate is applied to a forecast of how long the work will take.  Under the first model, the contractor is exposed to risk and thereby incentivised to work as quickly as possible to maximise profit; under the second model, the contractor is less exposed and may actually be unintentionally incentivised to take as long as possible.

Both contract types may use additional ‘key performance indicators’ (KPIs) that incentivise contractor performance through rewards and penalties but unless these are directly relevant to the specific scope of work, these can have unintended consequences.

How does it manifest itself?

Companies come to realise that they have incentivised behaviour that is unhelpful, detrimental or even potentially risky.  Under a fixed-sum model, short-cuts may be taken as a contractor seeks to ‘finish early’; conversely, with reimbursement, work may be prolonged unnecessarily as the contractor seeks to extract as much revenue as possible.

Examples from the news include:

·        The Domino’s Pizza chain’s guarantee to deliver within 30 minutes (customers whose deliveries were made after 30 minutes were fully reimbursed) was amended following high-profile traffic accidents involving Domino’s drivers.

·        Since the ‘credit crunch’, some bank bonus schemes have been revised to incentivise long-term performance since pre-2008 bonuses appeared to encourage excessive risk-taking in the pursuit of short-term gains.

What is its impact?

The skewed risk/reward balance in poorly negotiated contracts and clumsy KPIs can result in either work being performed too quickly (thereby adversely affecting quality and safety) or too slowly (thereby increasing costs and resulting in late delivery).  Failure to recognise the implications of the changed situation reduces management credibility and overall morale suffers.  Excessively punitive penalty clauses can force one side out of business, which often leave the remaining party out of pocket, without the goods or services it sought but now with the additional burden of finding a new supplier in even less time than originally.

Relations between client and contractor can become frayed as one side perceives the other to be ‘gaming’ and taking unfair advantage of clauses in the contract that are having unforeseen consequences.  In such circumstances, the long-term continuation of such business relationships is unlikely.

What recommendations are made to address it?

Client organisations that have ‘learned things the hard way’ through poor contracts and KPIs often subsequently seek to establish long-term relationships with their suppliers and contractors, dedicating time and resources to ensure they have a shared understanding over those clauses that contain rewards or penalties.  Another lesson identified from this is the need for rewards and penalties to be specific to the work in question and the avoidance of ‘one-size-fits-all’ KPIs.

These lessons were identified by clients in facilitated lessons capture sessions run by Knoco.  To learn more about these and other KM services, please visit the Knoco website.