From Penalties to Rewards - A Rational Shift?

In its 2005 Global IT Outsourcing Study, consulting firm DiamondCluster International Inc. found that 27% of buyers responding to the survey said they were issuing rewards last year, and most coupled them with penalties. An additional 48% administered only penalties yet are coming under increasing pressure from providers, 44% of which include rewards in their typical outsourcing deals, the study found.

The Wall Street Journal highlights how clients of outsourced services are shifting emphasis from penalties for non-performance to incentive structures that drive the provider to push the service envelope. While the structure of incentives varies widely, many focus on sharing the savings from cost reductions and the spoils from greater performance.

This shift from penalties to a shared reward system is reflective of a larger shift in the nature of the outsourcing relationship from an arm's length contractual arrangement that focuses on the specific terms of work to a partnership model that is sustained by the future value of the relationship. Therefore, negotiation and execution of incentive structures require more planning, attention and resources relative to a penalty system. Given the complexity involved in executing an incentive structure, one must ask - is this shift from penalties to rewards really required? What is the marginal increase in performance that will accrue on account of this shift?

The shift is not for all. If the process or function outsourced is complex, strategically important, and shares strong interdependencies with other business processes, the client firm might find the shift well worth the additional effort required to shift from control to coordination. If not, the shift may not merit the additional complexity of relationship management. An arms length contract that emphasizes penalties and control may be the most efficient means to leverage scale efficiencies and skill of the service provider.