Performance-based outsourcing

Common ailments can be cured by performance-based outsourcing.

By Kate Vitasek and Mike Ledyard

Several decades ago, EDS was the first to use the term outsourcing to describe their work maintaining large mainframe computers and data centers for other firms. Today, the term outsourcing is used in different contexts to describe a full range of service arrangements. The outsourcing relationship can be with another company that performs the work within your four walls, or with an entity halfway around the globe. Outsourcing can be a successful strategy for virtually every imaginable process — from building maintenance to logistics to manufacturing to IT support to foodservice to customer service and beyond. Any process that someone else can perform better, faster, or more efficiently than you can in-house, and is not your marketplace differentiator, is a candidate for outsourcing.

No matter why a firm outsources, almost all have room for improvement. Outsourcing deals often have been structured with fundamental flaws in the business model and the relationship. The flaws result in either direct negative behaviors or unconscious behaviors that drive unintended consequences. These inherent flaws are analogous to poison that causes disease or illness. These flaws in how companies structure agreements lead to what is known as perverse incentives. A perverse incentive is "an incentive that has an unintended and undesirable effect, that is against the interest of the incentive makers. Perverse incentives by definition produce negative unintended consequences," according to Wikipedia.

A classic example is from Hanoi when a French program paid people a bounty for each rat pelt handed in. The program was intended to exterminate rats. Instead it led to the farming of rats!1

Perverse incentives in outsourcing

So how does the concept of perverse incentives relate to outsourcing? Our research has identified the most common flaws we have seen afflicting outsourcing relationships. We can think of these as diseases — illnesses or bad habits — that weaken an outsourcing relationship. A few are obvious. Most are not. One characteristic these diseases all share is that they drive perverse behaviors, leading to uncomfortable relationships and wasted opportunities for gains in efficiency.

In some cases, the disease simply causes mild symptoms, so the companies or outsource providers never bother treating the condition. They suffer the symptoms, thinking they can learn to live with them, but the symptoms soon become so debilitating that they must be treated. Or they might have no visible symptoms, such as a person with high cholesterol; but if they avoid regular health care and never are diagnosed, their disease will weaken or harm them. In the worst case, the disease is so severe that it eventually causes the death of the relationship, which causes the company to either bring the outsourced services back in-house or switch vendors.

The diseases of outsource relationships

The first step to improve the health of your outsourcing relationship is to get the proper diagnosis. Unfortunately, many organizations that are involved in an outsourcing relationship don’t always know they have a problem. This article outlines three of the most frequent flaws of outsourcing business models that lead to perverse incentives.

1. Penny wise and pound foolish

Too many companies profess to have an outsource “partnership,” but behind the scenes they focus solely on beating up their service providers on price. The danger in focusing on the cheapest offer is like anything else — you make tradeoffs in quality and/or service.

  • In one extreme example, we witnessed a company re-bid its transportation services every three months. In this extreme case, the company had churned through virtually all of the top 20 suppliers during the course of a five-year period and were now forced to work with suppliers of lesser quality.
  • Another company (referred to by its suppliers as the “800-Pound Gorilla”) decided to outsource all of its manufacturing to allow it to focus on its core competencies. The company went through several rounds of extreme negotiations to save the last possible dime on a book-of-business worth roughly $100 million. It awarded the work to a $1 billion outsource provider. The problem? The outsource provider “bought” the business and eventually could not sustain the losses of profit. The provider gave the 800-Pound Gorilla a 30-day notice that it would no longer manufacture its products and eventually went into bankruptcy — tanking what was once a successful and profitable $1 billion firm.

Organizations that have this disease are the ones that give outsourcing a bad name — and should not be outsourcing in the first place. Their myopic focus might have good short-term payoffs, but this approach has proved time and time again it does not pay to be penny wise and pound foolish.

2. The outsourcing paradox

Another trap that many companies fall into is developing the “perfect” set of tasks, frequencies and measures. The “experts” within the company attempt to develop the “perfect” Statement of Work (SOW). The result is an impressive document containing all the possible details on how the work is to be done. However, this “perfect system” is often the first reason why the company will fail in its outsourcing effort. That’s because it’s the company’s perfect system, not one designed by the provider of the services.

  • During a site visit to a 3PL that warehouses spare parts, we saw about eight people servicing a facility that on average had less than 75 orders for spare parts per day. When asked why all the resources, the manager responded, “That is what the client company requires per our statement of work — so I have staffing at that level to meet the contract requirements.”

We continually are amazed to find that companies have chosen to outsource to the “experts,” yet define the requirements and work scope so tightly that the outsource provider winds up executing the same old inefficient processes!

3. The activity trap

Traditionally, companies that purchase outsourced services use a transaction-based model, where the service provider is paid for every transaction — regardless of whether or not it is needed. There is simply no incentive for the outsource provider to reduce the number of non-value-added transactions because a reduction of transactions would translate to a reduction of revenue. Even if the outsource provider’s profit is a fixed profit amount, the typical outsource provider will be penalized for investing in process efficiencies to drive costs down.

Perverse incentives also creep in. Nineteenth-century paleontologists traveling to China used to pay peasants for each fragment of dinosaur bone (dinosaur fossils) that they produced. They later discovered that peasants dug up the bones and then smashed them into multiple pieces to maximize their payments.2

The table below outlines some typical reactions we have seen as a result of the Activity Trap from companies that outsource third-party logistics services,

Company outsourcing for third-party logistics services Service providers typical reaction under a transaction-based model
I forecast over We charge you to store and count your product monthly … the more you have, the more we make.
I forecast under We charge rush fees to expedite your products to market.
I manage my suppliers poorly Your suppliers caused us to rework your product into new packaging. We have to charge you more money to rework.
Inventory working capital is killing me We don’t own your inventory … we just provide services to you. Actually, we like when you have too much because we charge to hold it.
I specified the wrong shipping requirements We ship as we are told. You didn’t tell us about the special label.
  • On a recent site visit, we learned about maintenance cards in plastic sleeves attached to the equipment. These cards showed the time, date and what maintenance was performed. The data also were entered into a database, where they was tracked and all reports were generated. The cards had not been used in 15 years, but still had to be completed. The customer acknowledged that the practice was outdated, but declined to remove it from the RFP/SOW.
  • On another site visit, we asked the general manager of a 3PL what the large area full of “orange tagged” pallets was for. She replied, “That’s some of our customer’s old inventory I need to move to an outside storage facility.” When we dug further, we found out it was product that was well over five years old — and at the rate it was moving it would last 123 years! We asked why they didn’t work with the customer to scrap the material. The response was, “Why? I charge $18 a pallet per month to store it. I’d lose revenue if I did that!” 
  • The third example comes from outsourced manufacturing. The particular contract manufacturer performed final kitting and assembly “pack-out” as a value-added service for its customer. The customer had given the contract manufacturer the bill of materials with detailed instructions to use a specified finished goods “pretty box” for the product. Each “kit” had multiple parts organized in a box. The contractor needed to assemble the box and then insert the parts in an organized manner. To build the box required the contractor to have 12 “touches” for which the 3PL charged a flat fee per touch to assemble the box carton and one “touch” for each item placed in the kit. The contract manufacturer knew that the particular box design was not efficient but simply did what it was told rather than proactively offer solutions for an improved box design that could eliminate touches.

The need for a better approach: The rise of PBO

The heart of the PBO is the agreement on what we called “desired outcomes.”

Now that you have a better appreciation for a few of the typical diseases that plague outsourcing relationships, you likely are asking yourself, “Is there a better way?” The good news is that thought-leading companies have been challenging traditional outsourcing models for more than 10 years. The result has been an evolution to a “next-generation” outsourcing model we call Performance-Based Outsourcing (PBO) that challenges traditional outsourcing approaches.

The heart of the PBO is the agreement on what we called “desired outcomes.” Desired outcomes explicitly state the results on which both companies will base their outsource contract. A PBO partnership clearly defines financial penalties or rewards for not meeting or exceeding agreed-upon desired outcomes. In a PBO agreement, regardless of what is being outsourced, the outsourcing partner has the ability to earn additional financial value (e.g. more profit) by contractually committing to achieve the desired outcomes. Simply stated — if the outsource provider achieves the desired outcomes (achieves results), it receives a bonus. Note: It is important to understand that PBO is NOT gainsharing.

The mind-shift change of PBO

It’s important to digest that PBO is much more than doing an activity at a higher level of service. For example, it is:

  • NOT about achieving 99% fill rate for your warehouse provider versus 95%
  • NOT about answering 95% of all calls in 20 seconds versus 30 seconds
  • NOT about achieving quality defects from 3,000 DPPM to 3.4 (six sigma) DPPMs from your contract manufacturer
  • NOT about ensuring that janitorial service provide clean the toilets every two hours
  • … and the list can go on and on.

PBO is a fundamental business model paradigm shift in how the company that is outsourcing and the service providers do business. Unfortunately, many people on both sides of an outsourcing relationship simply do not understand the fundamental business model concepts behind PBO. A common mistake occurs when organizations THINK they have a PBO because they have taken their existing contract and simply added that if the service provider achieves the metrics, they are paid a bonus. This completely misses the mark.

The University of Tennessee and the authors believe that PBO is a powerful strategy. We also believe that companies wanting to improve their relationships should have a sound guidebook. As a result, the authors have published a book on their findings, available for free, that includes all 10 of the most common diseases of outsourcing. It is available at http://PBOResources.utk.edu.

The University of Tennessee Center for Executive Education also has launched a new 2 ½-day class on the topic of Performance-Based Outsourcing: Buying Results, Not Activities! For more information, please visit http://PBO.utk.edu, or contact Bric Wheeler, director, at bwheeler@utk.edu, or call (865) 974-8759.


1Michael G. Vann, "Of Rats, Rice, and Race: The Great Hanoi Rat Massacre, an Episode in French Colonial History," French Colonial History Society, May, 2003
2Bryson, Bill, “A Short History of Nearly Everything”, Broadway Books, New York, N.Y., 2003