Don’t Fall into the Activity Trap

There are many "perverse incentives" in buyer-supplier relationships that can disrupt or even doom outsource relationships, but perhaps none of them are as perverse and downright dangerous as the one I call the Activity Trap. Transaction-based operating and pricing practices create this perverse situation. Why? Because the suppliers or service providers get paid for every transaction processed, whether or not it’s really needed. The more transactions processed, the more revenue for the service provider—there’s no incentive to innovate for cost savings or greater efficiencies, or to reduce the number of non-value-added transactions—even if it makes sense to do so, because it doesn’t make cents. In my classes I use the example of a rat on a treadmill when I talk about transaction-based business models. Why? Service providers typically charge a price per transaction (such as cost per hour/FTE, cost per call, cost per unit, etc.). The Activity Trap creates an inherent conflict between the buyers and suppliers—the suppliers are incentivized to do more transactions, or in the case of IT outsourcing, to send more data because it increases revenue for the service provider. One victim of the Activity Trap, a large technology company, was transferring sales support activities from one outsourced provider to another. The company found that the data required to run certain reports was no longer current, and the new data was being stored in a new format in a different location.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 the provider had produced over about five months were wrong. In a damage control drill, the team learned good news as well as bad news: the sales manager who had requested this reporting had been transferred, and the new sales manager did not use this (now inaccurate) report. However, it was still a required activity, and the technology company was being charged each month to generate the report. So the disease continued to fester. The Activity Trap lurks in a variety of transaction-based outsource arrangements. For example, when the contract structure is cost-reimbursement, the service provider has no incentive to reduce costs because profit is normally 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. So in a nutshell, the more inefficient the entire process, the more money the service provider will make. Do you see what I mean by perversity? Even more perversity occurs when it comes to incentives. Nineteenth-century paleontologists traveling to China would pay peasants for each fragment of dinosaur bone fossils that they produced. The paleontologists later discovered that peasants dug up the bones and then smashed them into multiple pieces to maximize their payments. Shifting to the highly collaborative Vested business model depends greatly on two factors: Is there a need and potential to create value and drive innovation? Another factor is the level of dependency that is required in the relationship—for example, the high cost of switching service providers. A company that is simply buying a commodity, and there is no potential to create value, should use the more conventional transaction-based business model, and does not need to delve into Vested’s model and methodology. But in complex, highly strategic outsourcing relationships, counting each transaction misses the big picture—it’s not about mere value exchange per unit of activity, it’s about the co-creation of value, about increasing the size of the pie for everyone at the table. Co-creation means charting new and unknown territories. The most important thing I and the University of Tennessee do is to teach business partners Vested’s collaborative, what’s-in-it-for-we, value-creating mindset—and to live the values of that mindset; the values that they create together. 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 identify the sneaky perverse behaviors that may be afflicting your outsourcing relationship. Previously, I looked at the Outsourcing Paradox and now the Activity Trap; next up: the Junkyard Dog Factor. About Kate Vitasek: Author, educator and business consultant Kate Vitasek is an internationally recognized innovator in the practice of supply chain management and outsourcing. Vitasek’s approaches and insights have been widely published in respected over 300 academic and trade journals and five popular books, including Vested Outsourcing: Five Rules that will Transform Outsourcing and Vested: How P&G, McDonald’s and Microsoft are Redefining Winning in Business Relationships. World Trade Magazine named Vitasek to their list of the 50 most influential people and ideas impacting global trade. Vitasek has been featured on Bloomberg Radio and Fox Business News sharing advice on how to create successful business partnerships. She’s been recognized as a "Woman on the Move in Trade and Transportation" by the Journal of Commerce, a "Woman of International Influence" by Global Executive Women and has been called a "Rainmaker" for her tireless effort in educating business professionals. In 2009 she was honored as finalist for a Stevie Award for woman entrepreneur of the year for her role in founding SC Visions – a boutique-consulting firm also recognized by ARC Advisory Group as "one of the Top 10 coolest consulting firms" specializing in supply chain management. Vitasek is a faculty member at the University of Tennessee’s Center for Executive Education. Prior to academia she held operational and executive roles with P&G, Accenture, Microsoft, Stream International and as Founder of SC Visions.

Don’t Fall into the Activity Trap

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