Building Flexibility Into Contracts
The main rationale for building flexibility into an outsourcing contract is based on the premise that factors both internally and externally may change and thus impact the achievement of the desired objectives of the outsourcing. For example, the internal requirements of the sourcing organization may change during the outsourcing contract or another supplier in the supply market may achieve a technology breakthrough, which allows it to realize significant performance improvements.
In the latter case, the establishment of a long-term contract with a competing supplier prevents the sourcing organization from accessing the superior capabilities of this supplier. Therefore, incorporating elements into a contract that create flexibility can ensure that the desired benefits are being achieved from outsourcing and in particular, ensure that the sourcing organization is not locked into a relationship with an uncompetitive supplier.
Likewise, building flexibility into contracts aids organizations in benefiting from the outsourcers’ cost improvements as they occurred, avoid lawsuits and save face in the future. Ways to Build Flexibility into Contracts McIvor (2005) related that flexibility can be achieved through either incomplete or incentive contracts. Incomplete contracting creates a situation in which parts of the contract can be renegotiated based upon changes in circumstances. It is mainly concerned with optimization over time, seeking to minimize the costs of adapting to the constantly changing conditions of the economic environment.
There are a number of methods incorporating flexibility into a contract through incomplete contracting like price flexibility, renegotiation, contract length and early termination (Langfield-Smith, Smith and Stringer, 2000). Price flexibility allows prices to be renegotiated as circumstances change during the contract. Incorporating price flexibility means that all future contingencies do not have to be fully considered at the outset, as the buyer and supplier are aware that prices can be adjusted to reflect changes in circumstances.
For example, changes in the requirements of the sourcing organization during the contract may necessitate an adjustment in prices. In renegotiation, mechanisms are incorporated into the contract that allow for renegotiation based upon changes in the business environment. The contract may include specific clauses under which renegotiation should occur including fixed calendar dates or changes in economic indices. Renegotiation often involves renegotiating more than price and can also focus on the terms of contract.
The employment of shorter contracts can be employed to achieve flexibility. At the end of the contract period a new contract can be negotiated that reflects the current circumstances both internally and externally. Rather than have the five- to seven-year contracts of the last decade, contracts are now being broken into manageable timeframes which have short initial terms and options for extensions. Few organizations can predict their needs with any certainty over long lengths of time, thus it is prudent to have flexibility over the contract continuance.
A clause may be incorporated into the contract that sets out the conditions under which the contract may be terminated. The omission of such a clause can result in considerable penalties in the event of the contract being terminated prematurely. Incentive contracting, on the other hand, involves incorporating mechanisms into the contract that allow the supplier to share any cost savings or profits generated through the outsourcing relationship (Dimitri, Piga and Spagnolo, 2006).
Taking advantage of a contractor’s general objective to maximize profits by giving it the opportunity to earn a greater profit if it performs the contract efficiently lies at the core of incentive contracting. The essence of said contracting type is the effort by one individual or organization (the principal) to induce and reward certain behaviors by another (the agent). It has been the subject of considerable discussion in the economics literature, as incentive contracts are often employed to encourage performance improvements in the outsourcing arrangement in areas such as cost reduction and service levels (Bolton and Dewatripont, 2005).
This type of contract stimulates the contractor to limit costs by leaving him a fraction of cost savings, but at the same time it reimburses him some money in case of cost overrun. The contract will include mechanisms that ensure the supplier shares any savings that are realized from performance improvements. Incentivization can create a more cooperative relationship between parties, overcoming the traditional adversarial approach to contracting.
The purpose of the incentives is not just to motivate the contractor but to tie performance of all participants to the contract’s objectives. The proper use of an incentive contract aligns the priorities of contract participants who would otherwise have diverse motives. Potential Risks of Building in Too Much Flexibility Nowhere is the potential trade-off between control and flexibility more apparent than when it comes to designing the contract. As with anything that is too much, there are potential risks of building in too much flexibility into contracts.
By having too much contract flexibility, short-term opportunistic behavior is more likely, which is why classical legal contracts remove flexibility by building in as much legally enforceable control as possible that protects both parties from such behavior. With respect to incomplete contracting, problems arise when any agreement is negotiated under conditions of incomplete or asymmetric information, risk and uncertainty. It has also been associated with certain organizational costs, as it needs to be revised or renegotiated as the future unfolds.
John (2000) identifies three such types of costs: ex post costs of haggling over the terms of the revised contract upon renegotiation; those related to inefficient agreements caused by asymmetric information; and ex ante costs of not investing in relation-specific investments in fear of encountering ‘hold-up’ behavior upon contract renegotiation. Since it is impossible to write a complete contract that specifies what the agent is required to do in all contingencies, legal precedent is employed to determine obligations of the contracting parties that are not explicitly written into a contract.
Familiar contractual forms have the advantage that there is a wealth of legal precedent concerning them. Thus, disputes are likely to be resolved speedily. More exotic contractual forms, for which there are few legal precedents, are more prone to costly and acrimonious legal disputes (Aghion and Bolton, 2002). Further, incomplete contracting discourages both relation-specific investments and value-enhancing agreements.
When it comes to incentive contracting which operates on the theory of the carrot and the stick (there’s a financial carrot for a supplier for better than agreed-on quality, reliability, delivery or performance and a financial stick for worse than agreed-on levels of those parameters), the principle is attractive but the practice is another matter. Suppliers are reluctant to accept financial penalties, especially for reliability targets are not reached, and customers are reluctant to extend financial incentives to suppliers if agreed-on targets are not met.
In incentive contracting, the risks’ amount, probability, and impact are major factors influencing the design of the contract since the main purpose of this is transferring the risks. As well, there are several limitations to incentive contracting, as it depends on a purchaser with the ability to specify performance, the possibility of meaningful performance measures that can be identified, agreed upon and implemented, the existence of resources to oversee and monitor performance, and the practical ability to take action, including replacing the contractor, where performance is unsatisfactory.
The front pages provide too-frequent illustration of the ways in which contract incentives designed by the best and most well-intentioned experts may yield unintended adverse consequences. Incentives can divert attention from other important goals, work too well on their own terms, or encourage distorted reporting. WORKS CITED 1. Aghion, P. & Bolton, P. (2002). On Partial Contracting. European Economic Review. 46, 745-753. 2. Bolton, P. & Dewatripont, M.
(2005). Contract Theory. Massachusetts: Massachusetts Institute of Technology. 3. Dimitri, N. , Piga, G. & Spagnolo, G. (2006). The Handbook of Procurement. New York: Cambridge University Press. 4. Langfield-Smith, K. , Smith, D. & Stringer, C. (2000). Managing the Outsourcing Relationship. Australia: University of South Wales Press, Ltd. 5. McIvor, R. (2005). The Outsourcing Process: Strategies for Evaluation and Management. New York: Cambridge University
