“It’s unwise to pay too much, but it’s worse to pay too little. When you pay too much, you lose a little money – that is all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do.” – John Ruskin
In previous blogs we explored risk allocation and highlighted the fact that inappropriate risk allocation significantly erodes value and creates an immense barrier to collaboration. We also observed that contractual risk allocation may often provide a false sense of security, especially in complex environments where uncertainty is rife, variations are prolific, and the customer rarely has clean hands. The solution is to select a commercial model that encourages a shared vision, shared risk and opportunities, and creates an environment where all parties win, or all parties lose. How then can we create such a commercial framework?
Money at any cost?
In terms of profitability, a reasonable risk-adjusted rate of return is to be expected across the enterprise. This does not mean that each project, contract, or activity will yield the same rates of profit, rather the enterprise as a whole should be generating suitable profits in the interests of shareholders, current and future. This latter point is very important as short-term profit taking must be discouraged.
Commercial models must never jeopardise buyer or supplier cash flow or place business continuity at risk. We should never underestimate the importance of money as a motivational factor but, at the same time, we must also need to recognise that it is not just the contract value and remuneration strategy that will influence behaviours.
Remuneration and risk
The remuneration options available for a contract almost limitless. We can select between the spectrum of cost-plus to firm fixed price arrangements, we can vary remuneration strategies throughout the contract life cycle, we can adopt different remuneration strategies for different packages of work, and we can frame payments in terms of sticks (liquidated damages) versus carrots (early completion bonuses). The challenge in crafting and negotiating a commercial agreement is to strike a balance that meets the commercial needs of both parties whilst at the same time creating a framework that encourages problem solving, innovation, and the delivery of enterprise outcomes. In other words, how do we drive collaboration through the contract?
Best Practice Risk and Remuneration Strategies
In Andrew Jacopino’s blog on perverse incentives, he explores the phenomena where seemingly valid incentives can drive the wrong behaviours. Our risk and remuneration strategy must be crafted to drive the right behaviours. To achieve this, we need to strike a balance between monetary (fees and damages) and non-monetary (e.g. contract extension, increased contract scope, preferred supplier status) aspects.
Incentive based remuneration helps align the parties’ interests and drive collaboration. Incentive fee reimbursement includes; cost plus incentive fee, cost plus fixed fee, and cost-plus award fee options. Remuneration of this type often requires the development of a Target Outturn Cost (TOC) against which the performance fee is determined. A focus on achievement of the TOC alone though is insufficient. The commercial framework should also allow for price adjustment based on delivery quality, schedule, and any other key result areas. Adjustment of incentive fees can be a based on a combination of both carrots and sticks. For example, our carrots can include a bonus pool set aside for early delivery or for achieving superior quality outcomes (provided such outcomes are of value to the client). Conversely, we can rely on sticks such as abating incentive fees for late delivery or where quality fails to meet minimum requirements. Such remuneration strategies must be crafted so that enterprise objectives are realised, all parties win or all parties lose, and the system is fair.
Challenges with Developing the Target Outturn Cost
The development of the TOC requires validation by the principal either by using inhouse capabilities or third-party estimators. Where there is an asymmetry of information, TOC integrity can introduce the risk that the TOC is set too high and result in erosion of value. Typically, the TOC is set at the most likely value or P50 estimate of costs. In some larger, complex projects the TOC may include an allowance for uncertainty (unallocated contingency).
Profit Sharing Arrangements
A more revolutionary approach for sharing risk and rewards is to adopt a profit-sharing arrangement. This could be through an incorporated joint venture or a commercial model that focusses on rewards directly linked to the client’s commercial outcomes. An example of this latter approach is with Seimens’ energy efficiency initiative with Pilkington. In this project, Seimens invested in energy efficient systems with upgrades to Pilkington’s equipment with the aim to reduce energy costs by £340,000 per annum. Rather than adopt a service contract or other risk transfer model, Seimens was remunerated based on energy costs saved. The client incurred zero investment costs under this initiative.
We must ensure profit or revenue sharing arrangements must also be fair. If too much risk is passed to suppliers, then project success is unlikely. The Boeing Dreamliner risk sharing approach where ‘no strategic suppliers will receive payment for the development cost until Boeing delivers its first 787 to its customers’ actually incentivised suppliers to deliberately deliver late. Situations such as this must be avoided.
Effective collaborative relationships must be underpinned by a fair and equitable risk allocation framework. Best practice risk allocation places an emphasis on risk sharing and incentive-based remuneration where buyers and suppliers are both liable for success or failure. We must be alert to perverse incentives in our commercial framework and strive to craft a commercial model that drives the right behaviours and is fair.
 US Government Department of Defence ‘Guidance on Using Incentive and Other Contract Types’ (March 2016).
 Qin Z., and Yang J. “Analysis of a revenue-sharing contract in supply chain management” (2008) International Journal of Logistics 11(1) pp 17-29.
 “Siemens supports Pilkington’s investment in energy-efficiency at zero net cost Case Study: United Kingdom” at https://assets.new.siemens.com/siemens/assets/api/uuid:4a52b5f48d29507018d85b6d13b0a248e8a1d81a/version:1510824643/sfs-uk-pilkington-case-study.pdf
 Tang, C.& Zimmerman, J. & Nelson, J. ‘Managing New Product Development and Supply Chain Risks: The Boeing 787 Case’ Supply Chain Forum: an International Journal 10 (2009).