Customers and suppliers alike maintain that they value innovation. But, far too many outsourcing contracts are full of perverse incentives that inherently disincentivise suppliers from investing in innovation. The result? A catch-22 where outsourcing relationships become a race to the bottom, a situation where organisations think they are spurring on innovation but, in reality, they are fostering the status quo.
Kate Vitasek, Professor in Supply Chain Management at the University of Tennessee, unpacks how transaction-based sourcing models are preventing innovation and shares how to move away from them in supply relationships.
What is the catch-22?
A Catch-22, the title of Joseph Heller’s classic novel, is a situation that traps people or organisations in contradictory, circular logic. For example, perhaps a pass is required to enter a particular building but, in order to get said pass, you must first go to an office in that building.
Outsourcing agreements are strewn with catch-22 scenarios that prevent buyers and service providers from achieving the full potential of working in a strategic manner to take advantage of each other’s core competencies. At the heart of the problem are conventional, transaction-based sourcing models and old-school procurement and contracting practices. To get a clearer picture, it is important to understand the behaviours created with transaction-based models.
A typical outsourcing deal pays a supplier for performing work on behalf of a buying organisation. Answer a call and get paid a price per minute or price per call. Provide logistics services and get paid a price for every pallet stored or each unit shipped. The result is the sad fact that service providers are in a virtual activity trap: the more activities they perform, the more revenue; the more revenue, the more profit. They may want to add value, but, typically, only get paid if such comes with billable activities or resources with hefty profit margins. Of course, this does make sense…what supplier doesn’t want to get paid for the work that it does?
But there are also flaws on the customer’s side. Many executives, whether in information technology, facilities management or logistics, say that they want a ‘strategic partner’. So, while their hearts and minds are going in one direction, their pocketbook and procurement create a countermovement. Old-school procurement processes emphasise ‘leverage’ and commoditisation to ensure that buyers get the best price for each transaction. Value? Isn’t that something suppliers include for free?
This is exactly where the catch-22 lies: buyers and sellers both want innovation but neither wants to change.
But, it gets worse… Contracts are often written that cement the catch-22 into contracting terms. Take, for instance, a typical termination for convenience clause. The buyer wants the supplier to invest in innovation. But why would a supplier’s Chief Financial Officer make any type of investment when they have a 60-day termination for convenience? In their eyes, any investment would have to have a two-month return on investment. And what in the terms suggests that any improvements become the intellectual property of the buying organisation?
Simply put, the outsourcing industry is in a rut. Buyers say they want suppliers to innovate, but they write contracts that stifle innovation and pit buyers and supplier against each other. Conversely, suppliers say they want to create solutions to solve customer problems, but fall into the trap of selling transactional billable line items. A catch-22 indeed.
Moving away from traditional transactional sourcing models
So, how can you get out of the catch-22 created by traditional transactional sourcing models?
One answer comes from Oliver E. Williamson’s Nobel Prize-winning research on transaction cost economics, which suggests that organisations can benefit from creating ‘hybrid’ business models with suppliers.
The Supply Chain Faculty at the University of Tennessee began studying hybrid approaches in 2003 as part of a larger research project funded by the United States Air Force. One very promising approach is what University of Tennessee researchers eventually coined as ‘Vested outsourcing’.
The Vested sourcing model combines three 21st-century ‘big ideas’ that are backed by research. When combined, these principles yield a greater value proposition than using transaction- or performance-based business models separately.
The first principle is to create shared value. Two advocates of shared value thinking are Harvard Business School’s Michael Porter and Mark Kramer, who profiled the ‘big idea’ of shared value in the January/February 2011 Harvard Business Review Magazine. Their article states that shared value creation will drive the next wave of innovation and productivity growth in the global economy.
Shared value principles are essential for averting catch-22s in outsourcing deals because they focus the parties on creating economic value in a way that expands value for all parties involved (grow the pie versus fight over an existing small pie). In essence, shared value thinking means entities work together to bring innovation that benefit both parties − with a conscious effort for them to gain (or share) the rewards.
The second principle is to make the shift to an outcome-based model. Outcome-based business models move the focus away from simply having a supplier perform work (transactions) to a focus where the buyer and supplier work in a highly collaborative manner to achieve business results (outcomes). Together buyers and suppliers challenge the status quo of how work is done and create solutions to deliver on desired business results.
A simple way to understand the difference between an outcome-based business model and a transactional or output-based business model is that an outcome-based business model buys a future (desired) business outcome. This is foundationally different from creating a model where the buyer purchases activities (transactions) or the supplier outputs (performance-based agreements). Key to outcome-based business models is the fact that true business outcomes almost always require the buyer and supplier to work together to achieve the outcomes much the same way a mountain climber relies on a Sherpa to reach the peak of Mt. Everest. A properly structured outcome-based agreement is bilateral in nature and shares risk as well as reward.
The last principle leverages the Nobel award-winning concept of behavioural economics. Behavioural economics was popularised by Stephen Levitt in his best-selling books Freakonomics and Super Freakonomics. The science behind behavioural economics received a credibility boost when Daniel Kahneman and Richard Thaler won Nobel Prizes in 2002 and 2017 respectively.
Behavioural economics is the study of the quantified impact of individual behaviour or of decision-makers within an organisation. The study of behavioural economics has evolved more broadly into the concept of relational contracting, which proposes that economic value can be expanded through positive relationship (win-win) thinking, rather than adversarial relationship (win-lose or lose-lose) thinking.
A well-structured relational contract flips a conventional transactional contract on its head because the former is a flexible contract framework centred around the rules of the relationship versus outlining the specifics of the ‘deal’, such as the statement of work or the price. Relational contracting is especially important when contracting parties operate in a complex or dynamic business environment and thus have a high degree of interdependency. It is also essential for coming up with fair ways to reward suppliers for investing in solutions, processes and technology that achieve the parties’ desired outcomes.
When the three principles are combined, outsourcing parties can create contracts that avoid catch-22 situations.
Averting the catch-22
Unfortunately, many procurement functions find themselves struggling with making the shift to highly collaborative relational contracts based on shared value/win-win thinking. But why? Many procurement organisations have deep-seated transactional approaches and performance metrics that are focused on getting the lowest price versus seeking to explore how to create value by fostering deeper business relationships.
Procurement professionals have also been taught to reduce dependency on suppliers and use heavy competition to attain the lowest price possible. Simply put, following some of today’s ‘best practice’ procurement practices actually prevent organisations from shifting away from a transaction approach.
University of Tennessee researchers offer the following five rules for making the required shift:
– Rule 1: outcome-based (not transaction-based) business model. Shift the mindset from a focus on specific transactions to desired outcomes – instead of buying transactions, buy outcomes.
– Rule 2: focus on the ‘what’, not on the ‘how’. A traditional specification-based statement of work dictates how existing work is done. Instead, create a bilateral process and focused taxonomy of the work and allocate responsibilities that challenge the parties to work together to improve the way the work is performed.
– Rule 3: clearly-defined and measurable outcomes. An outcome-based agreement focuses on desired outcomes. A well-structured outsourcing agreement replaces the multiplicity of service level agreements that measure transactions and activities, and instead shifts to, ideally, no more than five high-level desired outcome measures.
– Rule 4: pricing model with incentives that optimise the business. Making the shift to an outcome-based business model means making the shift to outcome-based economics. Gone are the days of billable line items and in its place is a pricing model with incentives that optimise the business. A key part of the pricing model is incentives that reward suppliers for making investments when desired outcomes are met.
– Rule 5: insight versus oversight governance structure. Rules 1 to 4 help parties to craft a Vested outsourcing agreement. Rule 5 enables the parties to sustain a pie expansion/pie sharing win-win approach throughout the life of the relationship.
The ‘rules’ sound fairly simple, but do they work? According to University of Tennessee researchers, the results for both public- and private-sector buyer-supplier relationships are spectacular. It appears that the outsourcing game can, indeed, be played successfully by using a different set of rules after all.