It's Time for a Risk/Reward System

Computerworld - In recent years, many companies have taken advantage of the difficult economy, demanding drastic price reductions and forcing suppliers to accept terms that result in little or no profit. While this approach may work temporarily, "vendor bending" is a shortsighted solution [see "A Squeezed Supplier Never Forgets," QuickLink 34182]. It's time for contracts that offer advantages to both parties.
Risk/reward contracts are an attractive alternative to traditional contracts. In these agreements, buyers risk paying more fees for the work but are rewarded by having their objectives met or exceeded. Suppliers risk reduced profits if they fail to deliver but are rewarded for superior performance.
Risk/reward contracts are especially effective for high-risk projects with significant business benefits. They distribute risk, provide benefits to both sides and align a company's interests with those of its supplier.
As an example, consider a high-risk project with a fair market value of $1 million and a monthly benefit of $80,000 when completed. In a risk/reward contract, the buyer pays $750,000 and agrees to pay the additional $250,000 "at risk" fee if the objectives and deadlines specified in the contract are met. (In general, these at-risk fees are set at 10% to 40% of the total contract.) If other "stretch" objectives are met, the supplier will be paid additional incentive fees. Incentive fees can be a lump sum or incremental payments based on project metrics or milestones. For example, there might be an early-completion bonus of $40,000 per month.
Risk/reward contracts are more difficult to create and manage than standard contracts and are generally unwarranted for commodity purchases. But for projects with high stakes, they offer significant benefits to both parties.
Buyer Benefits
Reduced risk. The fee structure shares the buyer's risk with the supplier. Most suppliers undertake risk/reward projects only if they are confident they can succeed. If you can't find any suppliers willing to undertake your project on a risk/reward basis, you may need to restructure the project to further reduce risk.
Aligned objectives. Some types of contracts give suppliers little or no reason to deliver on schedule. For example, time and materials contracts can actually motivate suppliers to extend projects to maximize their fees. In contrast, risk/reward contracts maximize the fees of suppliers that meet or exceed your objectives. In the construction industry, it's common for crews to work nights and weekends when the contractor faces deadlines that threaten big penalties or promise big bonuses. Similarly, risk/reward contracts can be considered an insurance policy against supplier underperformance.
Payments tied to results. Risk/reward contracts