Leveraging the Risk/Reward Contract

Risk/reward contracts are highly specialized and require careful and creative management. They take extra time and effort to construct , but in the right circumstances, they can provide benefits that more than compensate for that additional effort. These contracts motivate suppliers, through substantial penalties and incentives, to achieve your desired results faster and more effectively.

As an example, the 1994 Northridge earthquake destroyed significant portions of the Santa Monica freeway. The damage increased travel time for some commuters by more than two hours one way. The California Department of Transportation (Caltrans) created a risk/reward contract to speed the reconstruction effort.

The contract specified a penalty of $200,000 for every day the freeway remained closed past the 140 days that Caltrans engineers estimated it would take to rebuild the road. This was balanced by an incentive of $200,000 for every day the freeway was opened ahead of schedule. The result was that the freeway was reopened in a record 66 days, earning the construction firm a bonus of $14.8 million.

Managing risk/reward contracts often presents special challenges that demand a creative approach to project management. If you have signed such a contract, consider the following tips:

Give your supplier enough control to be successful. Remove as much bureaucracy as possible by providing creative solutions to common project roadblocks. As part of the Northridge reconstruction, for example, Caltrans arranged to have inspectors from the Federal Highway Administration available around the clock. As soon as a piece of work was completed, the inspectors approved the work and the construction company was able to move immediately to the next task. Removing the normal inspection delays greatly reduced the total construction time.

Communicate project benefits continually. It's critical to keep perceptions aligned when large incentive payments are involved. Otherwise, some people may perceive the incentives as unfair once the project is complete. For example, before the reconstruction of the Santa Monica freeway started, Caltrans calculated the cost of the closed freeway at $400,000 per day. But when the bonus was paid, a number of groups complained about the "excess profits" the construction firm received. Caltrans defended its supplier and said it was glad to see the contractors receive the deserved incentive payments. If your supplier meets the criteria for incentive fees, pay the bonus as agreed; don't quibble or whine. After all, you received the benefit specified in the initial contract.

Review metrics regularly. Don't wait until incentive payments are due to discover that you have differing perceptions of success. Review metrics with your supplier on a continual basis.

Share data freely. This may be uncomfortable for both parties, but it's often necessary to ensure proper payments. For example, measuring the benefits of a new inventory management system may require sharing some information that's normally closely guarded, such as inventory volumes, costs or turns. Similarly, the operator of an outsourced server center may be uncomfortable disclosing the current cost of its servers, since risk/reward contracts often have provisions to share savings resulting from reduced costs of hardware, software or telecommunications.

Align HR practices with project goals. If your supplier plans on paying incentives to its staff, be prepared to pay equivalent bonuses to any members of your staff who will work closely with the supplier and perform similar jobs. It may require a special exemption from human resources if your company doesn't normally pay bonuses to employees below a certain level. This won't be a concern in the case of wholly outsourced functions, but it will need to be considered in highly interactive projects that are jointly executed.

Don't be overly legalistic. Create a relationship with your supplier that fosters trust and cooperation. Risk/reward contracts work best when the two parties share a high degree of trust and a common goal -- yours! Be prepared to be flexible in order to achieve your desired results.

Risk/reward contracts add an extra dimension to all aspects of project management. In return, these contracts allow you to leverage the skills of your suppliers effectively while requiring them to share your risk. Use risk/reward agreements to align your suppliers' goals with your own and motivate the suppliers to outperform the terms of their contracts.

Bart Perkins is managing partner at Louisville, Ky.-based Leverage Partners Inc., which helps organizations invest well in IT. He was previously CIO at Tricon Global Restaurants Inc. and Dole Food Co. Contact him at BartPerkins@LeveragePartners.com.

Copyright © 2005 IDG Communications, Inc.

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