Contract LawOutsourcing & Projects

Incentives & Contracts: Part 2 – Marco Polo, KPIs & Bonus Incentive Schemes

Let me ask you a question: what does Marco Polo and a sophisticated customer of technology services in the 21st century have in common? The answer: they both know that in business, whether it is moving a camel train across the deserts of Asia, or ensuring that a supplier provides a quality IT project on time and on budget, they can employ two types of incentive schemes – the carrot or the stick – or a combination of both.

Incentive of the ‘carrot or the stick’

The structure of commercial contracts should reward good performance, and discourage poor performance. In a major technology project a customer needs to minimise project delay, cost overrun and poor quality of service. In a previous article I discussed the ‘stick approach’ to incentive schemes under a contract. Using the ‘stick’ approach the supplier’s motivation to meet contractual milestones and deliver the IT project on time is to avoid financial penalties or termination by the customer.

An alternative tactic to induce, manage and control the required level of performance from the supplier is to use the ‘carrot’ approach to incentives. Adopting a bonus incentive scheme model is a more positive approach and some commentators believe it is a better alternative to liquidated damages and other negative incentives. In this type of incentive scheme the customer will measure the supplier’s performance against set key performance indicators (KPIs) and the customer may provide bonus payments and other incentives if the supplier exceeds KPIs, delivery times or overall project accomplishment.

Key Performance Indicators (KPIs) – Time, Cost, Quality

In a technology law context, a key performance indicator is a method of measuring a party’s performance against set criteria or objectives set out in the contract. KPIs help mitigate identified contract risks and inform the customer of the supplier’s achievement and overall performance. In an IT project it is always advisable for the customer to include certain measurable service-based KPI metrics and negotiate these with the supplier on the basis that it encourages a collaborative partnership. The exact KPIs that you chose will depend on the context of your desired project outcomes. From a customer’s point of view it should require KPIs that are business and outcome focused. This will make sure that the customer only provides bonus and incentive payments as a result of the supplier taking visible steps to meeting the outcome focused KPIs.

Examples of KPIs include:

  • the supplier must meet each individual deadlines in the project plan
  • the supplier must complete the weekly costs vs. budget and personnel utilisation reports and deliver them to to the customer on time.
  • the supplier must, as necessary, update the scope of work and provide it to the project manager for review
  • the supplier must ensure that it and its key personnel and subcontractors attend and contribute to prescribed governance meetings with the customer

KPIs can be measured in a number of ways. A common method is for the customer to complete a scorecard or customer satisfaction survey at regular intervals and provide this to the supplier at a governance meeting for discussion.

Success bonus incentive scheme payments

The payment arrangements for the project can be structured in a way that rewards the supplier for achieving or overachieving in relation to a KPI target requiring it to meet a milestone or deadline. For example, the contract may state that:

  • the supplier has to complete a project milestone by 30 January and the customer will pay the supplier an incentive payment €50,000 if the supplier complete that milestone on time;
  • if the supplier does not complete the project milestone by 30 January the supplier receives no payment in respect of that particular project milestone; and
  • if the supplier completes the milestone 10 days or more before the due date the customer will pay the supplier an additional bonus incentive payment of 20% (or €10,000) in addition to the €50,000 that the supplier is entitled to for the meeting the milestone on time anyway.

Even if the supplier has fallen behind schedule for the first few milestones the customer can still keep the supplier incentivised throughout the project. One way the customer can do this is to include a clause in the contract that allows the supplier to ‘earnback’ any missed milestone payment if it exceeds a milestone objective for a subsequent milestone of the project. For example, if the supplier has missed the first two milestones and the attached €10,000 payments for each, but meets the third milestone 5 days before it was due, the supplier is entitled to the €10,000 payment for milestone no. 3 plus an ‘earnback’ of an additional €1,000 per day for overachieving on milestone no. 3 (in total a €5,000 extra bonus payment).

A final option its for the customer to set a fixed KPI date for completion of the milestone with a maximum incentive payment payable for on time delivery and then to reduce the incentive payment gradually for every day or week that the supplier is late delivering the milestone.

Balloon incentive payment scheme at project conclusion

Another type of incentive scheme is known as a balloon incentive payment. This will be familiar to US readers who can acquire a variety of goods, such as cars, for a low monthly instalment fee and then pay a lump sum at the end of the instalment repayment term. For example, in an IT services contract worth €1,000,000 the customer can pay the supplier a fixed monthly fee of €60,000 for 10 months during the project. The customer will withhold 40% of the total fees and will only pay the final lump sum (the balloon incentive payment) of €400,000 at the end of the project when the installation of the IT system is complete and it has passed all acceptance testing. However, in my experience suppliers will try to resist this structure in major projects where there are a number of dependencies and inputs required from the customer. This is because the supplier will argue that it is incurring the risk of non-payment of a substantial amount of the fees if there are any delays, including any delays out of the supplier’s controls of delay that the customer contributes to.

Cobra Effect – Law of unintended consequences

If the customer choose an incentive scheme the contract should clearly state that any services or deliverables the supplier presents early must still pass all acceptance testing in the first round. This helps avoid the law of unintended consequences or ‘cobra effect’ where prescribed incentives back-fire. In the instance of bonus incentives for early delivery the supplier may be motivated to rush the service or deliverable in an effort to secure the financial bonus and it may sacrifice the quality of the end product in the process. Withholding part or all the fees may also motivate the supplier to commence disputes regarding extensions of the time and extensions of the milestones in the event a delay has been caused or contributed to by the customer.

Failing to meet KPIs – Action plan followed by termination

The reality is that no matter how well drafted the contract and how balanced the parties’ incentives are things go wrong in major IT projects. Consequently, as the supplier may not meet one or all of the KPIs set out in the contract a customer should include a clause that allows the customer to direct the supplier to draft an action plan that the supplier must follow to remedy the cause of the KPI failures. A customer should also consider including a right to terminate the contract (or part of it) if the parties are unable to agree the action plan within a reasonable time, or if the supplier continues to fail to meet the applicable KPI after the action plan has been put in place.

Conclusion – Customised incentive scheme

Things haven’t changed much in 800 years. Both Marco Polo’s camels and IT suppliers can react well to negative incentives such as liquidated damages and the fear of being hit with the ‘stick’ if they do not perform. Conversely, they may react better to the ‘carrot’ approach where they are incentivised with a collaborative partnership that rewards them for overachieving.

Whatever you decide the most important thing is that is a degree of structure in relation to the delivery of the project to ensure the effectiveness of the supplier’s performance for each component of the project. As each customer and each project will have different needs and different goals, customers should consider the appropriate incentive scheme, such as liquidated damaged, KPIs/bonus payments, or a combination or both, and ensure it customises the incentive scheme for each major IT project that it undertakes.

 

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2 thoughts on “Incentives & Contracts: Part 2 – Marco Polo, KPIs & Bonus Incentive Schemes

  1. Hi Mark. I note your discussion and analysis on incentive payments. What is your view about the situation where there is a breach by the supplier and the questions arises as to whether the supplier would have to pay back the incentive payments on termination? Is this a normal practice and could this repayment ever be considered a penalty as it is not an accurate pre estimate of loss? Thanks!

    1. Hi Robyn, first of all thank you for contributing. As you will know a contract can contain a term allowing a party to terminate the contract as a result of the other party’s material breach. If the customer terminates the contract for the supplier’s material breach, the customer can also bring a claim for damages. However, punitive damages are not avaliable in contract law.

      Unless there was some sort of specific repayment mechanism activated automatically on termination in respect of the incentive payments, I do not believe that the supplier would be obligated to pay back the incentive payments simply because the customer terminates the contract. That being said, if the customer successfully brings a claim for damages against the supplier for the loss the customer has suffered, the supplier will have to compensate the customer. So through this damages amount there may be an indirect repayment of the incentive payments that the customer has paid to the supplier.

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