Why do so many traditional performance-based contracts end in tears? Frequently such deals generate nothing but suspicion, acrimony and confrontation. Suppliers often complain that they have been bashed over the head with a mallet, reduced to a degrading form of industrial serfdom, while the client feels aggrieved that the supplier hasn’t delivered the cost reductions or innovation promised. Even if the contract somehow runs its course, both parties are desperate to end their excruciatingly painful relationship.
There must be a better way, surely. After all, if you always do what you always did, don’t be surprised if you always get what you always got. In other words, if you continue to adhere to traditional performance-based contracts, the likelihood is you are setting yourself up for failure. That’s because they are based on two opposing objectives, explains Vince Edge, EMEA senior manager for supplier governance for Johnson & Johnson, the healthcare, medical device and consumer goods group. “The client wants innovation and cost reduction, while the outsource partner wants an increase in revenues, on which the size of their management fee will be determined,” he says.
Inevitably that lack of shared vision and objectives can sometimes lead to acrimony and break-up. A new contractor is eventually engaged and the whole process begins again. It is a grim cycle that Edge is all too familiar with. He has been managing such outsourced contracts for close on 20 years, either directly or on behalf of various global companies, including previously at Virgin Media. A self-confessed “toughie”, he once thought, like many others who hold similar positions, that it was his job to crack the whip and micro-manage suppliers until he underwent something of a damascene conversion several years ago after upsetting an employee of a supplier, who has since become a close friend. “I suddenly realised just how unsupportive my behaviour was and that there must be a better way, so I decided I would go and find out.”
The desire to create a more supportive environment where more positive relationships could flourish was just the start as Edge embarked upon his journey towards vested contracts. He is now a certified deal architect graduating through the University of Tennessee’s Executive Education programme. Controversially, the journey often begins with a long, hard look at the way retained organisations, brought in to manage outsourced relationships, conducts themselves. “In many of the cases where relationships go awry, it all boils down to the way that the retained organisation, the team directly employed by the client to manage the outsource partner, had conducted itself with during the relationship,” asserts Edge.
The behaviour of the retained organisation has a direct impact on the performance of the supplier, as does the company culture of the client. These factors, when not aligned or supportive of the relationship, result in the perception that the service provider is not performing. Even if they are performing, sometimes that gets overlooked as a result of the poor relationship. “If your KPIs are green but the internal noise from your retrained organisation says your partners are not performing, it may be time to take a look at the behaviours of your retained organisation rather than your outsource partner,” says Edge. “The key here is to look at how they interact with the service provider: do they take a supportive or an overly directive approach?”
So, what exactly is a vested contract and why might we consider it for certain types of contracts within B&I catering? Quite simply, a vested contract, or vested outsourcing, is a hybrid business model whereby both parties – corporate client and supplier – focus on shared values and goals to agree a contract that is mutually beneficial to both. As Edge, who recently talked about his vested contract journey at a recent Hospitality Network lunch in London describes it, it is “the closest relationship you can get to a partner, short of entering into a joint venture”.
What you can’t do, he stresses, is simply set up a vested contract without first doing a great deal of relationship building beforehand. Success rests on building the right cultural underpinnings, something in itself that involves a great deal of concerted effort by all parties involved, and suggests that this type of contract may be only suitable for medium- to large-sized contract due to the effort involved in setting up.
That process of relationship building also needs to take account of non-vested stakeholders; those who are indirectly involved and who could pose problems, especially if they continue to adhere to a more traditional approach in the management of supplier relations. For example, you might have a chief procurement officer who is typically focused on cost reduction and whose management style involves a great deal of fist-banging on tables. Dealing with that can be challenging and time-consuming in any situation, but especially a with a vested contract. “We did a hell of a lot of work to mend fences with our partners in 2015 and in 2016,” says Edge. “We needed to rebuild the culture and the relationships. You absolutely need to get this right before signing off on a vested contract.”
External support is often required. Edge and team relied upon EY (formerly Ernst & Young) to assist with contractual details to help facilitate the cultural change required. “This is not something you can adopt by simply going out and buying a book on the subject,” says Edge.
Once that cultural groundwork has been completed, you can then progress to implementation of the vested contract itself, a process whereby both parties agree to support each other to ensure mutually successful outcomes. Creating a financial structure that supports both parties is key to vested contracting. Driving a financial model that rewards rather than penalises cost reduction and innovation is one of the success factors of a vested contract. “Rather than saying to our partner ‘we want a 5% reduction and you can just take a haircut by reducing your margin’, under a vested contract, their profit is actually a consideration and something that is not a target to cut,” explains Edge. “The ethos is about ensuring the relationship is win/win, rather than win/lose.”
For example, assume you have a contract worth £100m where everything is predicated upon the total cost of ownership. Total cost of ownership means you include all costs associated with the delivery of the service, including the retained organisation. That model also involves the cost savings that the company wants to achieve, while ensuring the partner achieves its agreed profit margin too. Crucially, the partner can earn their profit by finding savings, which it shares on an equal basis with its partner by applying a gain share approach, as well as other financial mechanisms to drive behaviours to benefit both organisations.
Many contracts are built on a win/lose ethos. For example, a client and supplier enter into a typical performance-based contract with a value of £100m per year. The supplier will charge a fee to manage the services provided, as an example, say, 5%. So here is the issue: the client wants to see the £100m reduced. The supplier wants to see the £100m increase because their fee is a percentage of that value. As the £100m increases, they earn more – and this is where the misalignment starts.
Traditionally, what happened with a performance-based contract was that the supplier would have been told to deliver X% of savings in year one of the contract. The supplier delivers those savings, only to be told to deliver a similar level of savings the following year. “The supplier comes back the following year with some savings, but then looks at how they can recover the costs via other opportunities,” says Edge. “This is not unusual nor underhanded by the partner, it’s the game that is created by the customer through the procurement team and the retained organisation.”
Under a vested contract, and based on a win/win approach, the supplier is encouraged to reduce cost and rewarded via various financial incentives. One example of this is ‘gain-share’. So, if a supplier delivers, for example, £1m of savings to the client in the first year, they retain £500,000 in the year delivered if the savings are perpetuated. The customer takes the full benefit from year two onwards. This creates an environment of reward and absolutely aligns both parties to achievement of the same goal.
Another example is to fix the fee, in pound value terms, so that if the partner delivers savings that reduce the £100m, their fee remains the same but their gross profits increase. They may be participating in a smaller pie, but their share of it has increased – just as long as they go on reducing the size of the pie. In other words, the supplier is incentivised to deliver meaningful cost savings and real innovation in order to maximise its share of the profits. “What you get is real savings and real innovation – things that will genuinely improve costs and service,” says Edge.
Edge is currently working in a vested contract which needs to remain confidential. However, savings have been made but service levels, which are carefully monitored with agreed key performance indicators, fully maintained. The contract is also independently approved as a vested contract and was accredited by the University of Tennessee in the United States.
Such contracts are not for the faint-hearted and they may not be suitable for every company. They do involve far greater levels of endeavour than with traditional contracts in their setting up, but they also deliver far more tangible benefits. As Edge asserts: “The world is changing and there is a growing realisation that companies need more enduring and fruitful partnerships to prosper.”
It seems that vested contracts provide a very real opportunity to end the acrimony and distrust that permeates so many other contractual relationships. They are increasingly being pioneered by global leaders in their fields, such as Johnson & Johnson and CBRE, and offer what appears to be a highly promising route to better and more profitable business.