Incentive contacts: motivating performance and allocation risk.(Special Feature)(Report)

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Introduction

Contracting--an integral part of the logistics process and a formal subdiscipline within the logistics umbrella--is undergoing substantial philosophical and procedural changes. Table 1 on page 4 summarizes the continuing movement from what might be called classical contracting to New-Age Contracting. (1)

In classical contracting, the buying organization seeks the minimum contract price from a wide field of contractors based upon the competitive bid process. Contracts are typically fixed-price and the parties perceive each other as having competing objectives. In New-Age Contracting, world-class contractors with leading-edge technologies are important partners to the buying organization. New-Age Contractors assist in defining requirements--collaboration is essential, and long-term relationships are important. Contract terms are negotiated and incentives to motivate performance and allocate risk are typically incorporated. (2)

This article considers various types of incentives that can be introduced into contracts, presents both a mathematical and graphic presentation of various types of incentive contracts, and demonstrates how incentive contracts not only guide contractor performance to the advantage of the buying organization but also allocates risk between the parties.

Key Decisions in Procurement

The critical decisions in procurement are as follows.

* The nature of the specifications

* Contractor selection

* Price

* Contract type

* How to manage contractor performance

Classical contracting focuses primarily on the first three critical decisions. New-Age Contracting, on the other hand, adds emphasis to improving performance with collaborative buyer-contractor relationships and to contract type. Judicious attention to contract type will appropriately allocate risk between the buying organization and the contractor and will motivate performance.

The Issue of Risk in Contracts

Contract risk is of four types.

* Failure to perform

* Cost

* Technical

* Schedule

Failure to perform means the chosen contractor is not capable of meeting his contractual obligation. Cost risk is defined as uncertainty in final costs to the contractor and uncertainty in final financial obligation of the buying organization. Technical risk relates to quality issues and compliance with the technical specifications of the contract. Schedule risk is whether the deliverables of the contract will meet the required contract time schedule.

Failure to perform is not a significant risk issue when financially stable contractors with solid performance histories are selected. The formidable risk challenges in contracting relate to cost, technical, and schedule issues.

Contract Type and Cost-Risk Allocation

A fixed-price contract allocates all cost risk to the contractor. Regardless of what his actual costs turn out to be, the contractor is obligated to perform the requirements of the contract and will be paid only the fixed contract price. Obviously, the contractor has an incentive to control costs because of the dollar-for-dollar inverse relationship between cost and profit to him.

At the other extreme, a straight cost-reimbursable contract allocates all cost risk to the buying organization. The contractor has no incentive to control costs because he or she gets reimbursed dollar for dollar by his or her customer.

Incorporating Incentives into Contracts

Incentives in contracts will not only motivate performance and award achievement, but incentives also allocate risk between the parties. The important role incentive contracts play in New-Age Contracting was …