Incentives, Rewards, Penalties, and Damages

Everyone has heard of “the carrot and the stick” as ways to drive performance.  The carrot is the incentive or reward, and the stick is to prod performance. In contracts, the carrots are the use of incentives, or rewards to provide incentive for the Supplier to manage to the desired performance.  The stick is the use of penalties or damages for failing to meet performance. In most cases, the approach you select doesn’t have to be an either / or situation as both may apply.  For example, you could include a financial incentive for the Supplier to complete the work on an earlier date. If that incentive isn’t sufficient to drive the Suppliers behavior, you still need the penalty or damage should they not meet the required date.

There are a number of different carrots or sticks you can include in a contract. For example:

• Value engineering provisions are used to enlist the Supplier in trying to help reduce the cost of the work where the Buyer and Supplier share in the savings. 
• Provisions that provide for a sharing of savings with Suppliers for them helping reduce the cost of purchases and subcontracts are used for the same reason. 
• Incentives or rewards can be paid for early completion of the work.
• Rewards could be paid for the work exceeding certain agreed goals.
• Additional business may be committed based on exceeding performance goals
• Price adjustments, penalties, damages or other remedies can be included for failing to meet agreed commitments or goals so if the Buyer receives less they pay less, and any additional costs they incur are covered by the Supplier.

One of the keys in including any type of incentive or reward in a contract is to make sure that the Supplier will only receive it if the Buyer actually benefits from it. You want to avoid situations where a Supplier could claim that they are owed compensation, as they would have earned it but for the acts of the Buyer or another Buyer controlled supplier.  One of the keys in creating any penalties, damages or remedies is under most country laws they need to approximate your loss and cannot be punitive in nature.  For example any liquidated damages should represent the approximate costs you would incur.

Which approach do you use?  My simple rule is that if the desired performance or meeting the goal will provide increase value to the Buyer or reduce the Buyer’s costs, incentives or rewards are appropriate. For example, if you are purchasing a service and there are goals regarding uptime for the service and the Supplier exceeds those goals, an incentive or reward may be appropriate. You just need to make sure the bar for providing those incentives or rewards is high enough. If the performance won’t provide any incremental value or savings to the Buyer, using penalties or damages is more appropriate.  For example, if you leased space to move offices and hired a contractor to modify the space to meet your needs, you may not have any benefit of the Supplier completing the work early, but would have a major impact if they failed to complete on time.

The same type of reward / penalty can also be used in annual negotiations.  In one year we implemented a program to measure the total cost of doing business with a supplier based on only one metric – delivery performance. In the next negotiation we produced a summary of what the Supplier’s performance was and what their performance cost us in terms of inventory carrying cost.  The negotiation then came down to telling them that they needed to reduce their price to take into account what their performance cost us, or they needed to commit to improve their performance.  Most wanted to make commitments and the commitment could have been structured as either an incentive or penalty. The incentive approach would be to pay the Supplier the reduced price where they could earn the full price by meeting performance goals. The penalty approach would be to assess damages for each time they failed to meet the committed performance.

Incentives can also be a tool in price negotiations.  For example in purchasing advertising services there is always a conflict between procurement (who wants to reduce cost by reducing the fee) and the internal customer (that want to get the maximum benefits from the advertising program). One way to avoid this conflict is to work with the internal customer to establish goals they want met and use those goals for the Supplier to earn the full compensation. In this the base price would be discounted and if the Supplier met all the goals of the program they would earn their full fee. If the goals aren’t met, you pay less because you received less value.  If the goals are met you pay the full price but that will probably be far less of a cost than the financial benefits you will get from meeting the performance goals.  

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