Are You Embedding Perverse Incentives in Your Outsourcing Agreement?

Incentives are usually considered a good thing, right? They encourage engagement, investment, and innovation. Then why has the topic of "perverse incentives" gotten so much traction? For one thing, the economist Steven D. Levitt (and Stephen J. Dubner) notably and entertainingly writes about "the strange and powerful nature of incentives" in two huge bestsellers, Freakonomics and SuperFreakonomics. So what exactly is a perverse incentive? It’s a type of unintended consequence. For example, in Vietnam under French colonial rule, a program that paid a bounty for each rat tail handed in was intended to exterminate rats—instead it led to the farming of rats. Levitt says perverse incentives can happen anywhere. But can they happen in outsourcing? Can they creep into your outsourcing relationship? The simple answer is YES! I am so fascinated by perverse incentives in buyer-supplier relationships I devoted an entire chapter of my first book1 to the concept of perverse incentives in outsourcing. I thought I would share some of the wisdom and lessons I have learned along the way. Having sat on both the buy and sell side of the negotiation table, and as an advisor and now an academic, I have a unique ability to see these sneaky little perverse behaviors that may be afflicting your outsourcing relationship. I’ll start with my favorite – what I call the Outsourcing Paradox. The Outsourcing Paradox happens when a company has decided to outsource—hiring a service provider as the "expert"—and then proceeds to tell the provider precisely how to do the work. The company develops the "perfect" set of tasks, frequencies, and measures into a detailed Statement of Work and SLAs. This creates at best an uncomfortable situation for everyone. [eventpdf] Don’t think it happens? Let’s look at Statements of Work. We feature the P&G/Jones Lang LaSalle Vested relationship in: Vested: How P&G, McDonald’s and Microsoft are Redefining Winning in Business Relationships. The P&G/JLL team created a 61-page SOW that defined expectations of the Scope of Work for which JLL took responsibility. That may seem like a long document, but considering the scope and scale of work, the P&G SOW pales in size when compared to other facilities management SOWs. For example, I came across a SOW that is more than 800 pages long, and, among other things, describes in detail how long to cut the grass and how frequently. So how can P&G feel comfortable "letting go" and avoid the Outsourcing Paradox? By rigorously following the five rules for creating highly collaborative, win-win relationships. Simply put, JLL is vested in P&G’s success, and if it doesn’t hit a home run for P&G, it will not do well in terms of financial performance. In structuring the JLL agreement, P&G has done a fabulous job of applying Rule #2 – Focus on the What, not the How; and Rule #5 – Insight vs. Oversight Governance Structure. Both rules are essential to avoid the Outsourcing Paradox – and both rules go hand in hand. If you are going to learn how to "let go," you have to learn how to manage your outsourcing relationship in a very different way: through insight versus oversight. Good governance is not about micromanaging the supplier, it’s about learning how to manage the business with your supplier. Start by really understanding your core competencies and make a firm decision about what you are prepared to "let go." If you are not willing to "let go" then my advice is to keep the work in house or seek a simple labor arbitrage/staff augmentation type of relationship versus an outsourcing relationship. Then, seek out a supplier where you can foster a high degree of compatibility and trust as you develop your relationship. I recommend using a "Request for Partner" process instead of a conventional "Request for Proposal" process. As the P&G case study profiles – cultural compatibility and the conscious decision to build a trusting relationship was a key factor in the success of its outsourcing effort. Finally, once you have made the decision to "let go", you’ll need to prepare to physically shift the resources and skills of your "stay back" team. They will need to learn how to manage with insight – not oversight. I am not saying this means "throw the work over the wall", but rather that you need to invest in sound governance, with the focus on managing the business with the supplier, not just managing the supplier. Companies and service providers often complain, "It’s too late – we have already fallen victim to the Outsourcing Paradox. How do we get out of it?" One way is to seek to understand the structural flaws in your existing relationship. The University of Tennessee offers a free online self-assessment that can help you understand what factors are contributing to your issues. Once you understand where you have accidently designed in structural flaws to your existing agreement, you can begin to restructure your agreement to eliminate the perverse incentives that have crept in. For those who have not started the process of outsourcing, my advice is to make the tough call that if your team perceives they are better than the supplier, save yourself future pain and suffering and just keep the work in-house! Footnotes 1. Vested Outsourcing: Five Rules That Will Transform Outsourcing

Are You Embedding Perverse Incentives in Your Outsourcing Agreement?

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