When looking to create a new sourcing relationship, there are many elements to consider and many organizations ask themselves: “which model is most appropriate for me?”.
In the absence of clear guidance, many organizations fall back on historic sourcing models and tweak these familiar types of relationships, rather than risk a new unknown approach – and let’s be honest, the vast array of models that have arisen over the past decade doesn’t make it easier. There seem to be a vast array of options: managed service, prime contractor, agile framework, XaaS, T&M, etc…
Companies that pride themselves on being a frontrunner tend to jump to the latest hype and try it out. More conservative organizations hold back and stick to more traditional models. The results either way make for good blog material – both positive and negative – but the overarching understanding of how best to apply different sourcing models is not improved – this key question remains unanswered.
There’s no “one size fits all”
At the risk of stating the obvious, the starting point is that there is no single sourcing model that covers all situations. There are however models definitely unsuitable and ill-advised for some situations. The selection of a sourcing model is about identifying the scope and structure that best fits the main forces driving value – for both the client and crucially, the service provider.
There are two main challenges related to effective selection of sourcing models. The first is getting clarity on what a sourcing model really is. Frequently, there is an intermixing of terms used in the world of sourcing models, this includes pricing/payment terms (Fixed price, T&M, gainshare, etc…), accountability models (prime contractor, managed service, etc..), and even vendor strategies (preferred supplier, innovation partner, etc…). This can make understanding and choosing sourcing models confusing. The second challenge is a lack of clarity on how to accommodate the business and commercial forces that drive a best fit between a sourcing model and sourcing results.
1. What is exactly a sourcing model?
The definition of a sourcing model is simple. It answers the question: “How do you reward suppliers for what they contribute to the business?” In other words: “What is the economic model?” In this context, ‘reward’ means more than just payments, it includes IP, market access, bonuses, etc… Anything that is of value to the supplier. ‘Contribute’ likewise means more than just meeting service metrics. It means products, services and service improvement, knowledge, risk reduction, innovation, revenue growth, etc… Anything that is of value to the business. It’s further helpful to look at sourcing models in relation to contribution and reward because it helps clarify the most critical terms to include in the contract: objectives and key results, behaviour/knowledge expectations, service definitions and boundaries, warranties (typical contribution considerations), and also terms on payments, IP, limitation of liability and acquired rights (typical reward considerations).2. What drives the best fit between a sourcing model and sourcing results?
To answer this question requires a meaningful examination of risk. Too often in sourcing projects, risk assessments are outward looking and limited to vendor, financial and service risk.
- Vendor risk : are they trustworthy, ethical and solvent?
- Financial risk : can we maintain control of costs within acceptable targets?
- Service risk : can the required quality and speed of service be delivered?
The result of this limited outward looking approach is that it produces sourcing relationships based on controlling a supplier, rather than controlling relationship value. A meaningful examination of risk also requires examination of the risks to value for the supplier as well. There are two questions required in a meaningful risk assessment: a) “what are the risks and unknowns in our understanding between the inputs (efforts/costs/resources) my suppliers needs to make/use to provide the contribution expected by the client” and b) “which party to the relationship is in control of these risks?”.
The diagram below explains this in more detail. When sourcing, it is not enough to simply have the content of the contribution or value chain from intent to activity understood, it is the risks in the value chain itself that are critical and must be understood. These mean that efforts, activities and costs invested by a supplier may not produce the intended result, and it is therefore the control and management of these risks that drive business value and ultimately determine the best fit model of how to reward a supplier for their investments made to meet expectations on contribution.
The risks and unknowns in the value chain may cover a broad spectrum of areas in addition to traditional vendor and financial risk:
- Strategy: how clearly can the business define required / expected contributions by service area? Do these contributions clearly / one to one links intends? Are requirements likely to change? Is stakeholder buy-in low?
- Service and delivery: are the activities, technologies, knowledge needed to deliver services complex, difficult or scarce? Are policies and regulations applicable to services ill-defined or dynamic?
- Coordination: are interfacing processes and tools ill-defined or missing? Are interfacing teams at the same level of process maturity? Is technical / physical access and integration to business environment understood?
Clearly, if there is a high level of uncertainty and risk in the value chain and it’s unclear who should mitigate the risks, there is a good chance that the supplier investments won’t yield the intended business results. This is the situation that leads to breakdown of sourcing value and relationships.
Another way to look at this is that these two questions offer a powerful means to recognize and manage the two universal sources of tension within sourcing. The first is that supplier needs to make a profit while the business needs to maximize value at the lowest possible cost. The second is regarding clarity of accountability. As a starting point, responsibility and incentive to mitigate and own risk should reside with the party that has best control of a risk. Too much shifting of risk onto non-controlling parties typically yields failed delivery or skyrocketing costs.
Using risk to determine the best fit model
Now you understand the basis for determining the best fit sourcing model.
- A clear, realistic and comprehensive definition of supplier contribution is needed.
- A clear and realistic identification and assignment of risk between supplier activity / resource use and realized value is needed.
- The supplier reward model should fairly compensate supplier activity / resource use and incentivize ownership and reduction of risks placed in their domain of control.
Note that different services may have different contribution and risk profiles, therefore multiple sourcing models may exist within a single sourcing agreement. This is also why it’s important to understand what a sourcing model is, because without this, it is too tempting to apply a single model across a whole contract or relationship. This blanket approach has a high risk of undermining the sourcing value for both sides.
When looking at sourcing models in this way, there are actually only three possible models that result based on where risk ownership resides. (For those interested in working with contract templates, we therefore advise that you develop a standard contract template for each model below – see our up coming whitepaper on contract document templates to speed up sourcing without introducing risk).
Transactional
In a transactional model the supplier is paid for every individual transaction. This can be per hour, per mile, per minute, per activity or per unit). The more transactions, the more revenue a supplier earns. The supplier’s resources don’t need to undergo a significant transformation before they are sold to the customer, which makes it a low risk model for the supplier. The client utilizes the resources to create the intended business value, which makes it a high risk model for the client. Negotiations in this model are typically distributive by nature with a focus on competing over a fixed amount of value – that is, slicing up the pie between the parties.
Output based
In an output based model the supplier is paid for a product or service provided. Typically, tied to the achievement of pre-defined measures, such as product quality attributes or process based Service Level Agreements (SLAs). The contribution is a (semi) finished product or service with a business value superior to that of a more simple transactional contribution. Performance-based agreements are more relational use output-based economic models where a buyer negotiates pre-defined efficiency or performance targets. Because the supplier needs run a process to produce the output to the customer’s needs the value chain risk for the supplier is higher than in a transactional model
Outcome based
An outcome-based economic model is more sophisticated than one that is output-based because it typically ties the supplier’s payment to mutually agreed-upon and boundary-spanning business outcomes – captured in Objectives and Key Results (OKRs) – not just a product, process or functionally focused performance outputs. To achieve true business outcomes, a buyer and supplier must work together in a highly integrated and collaborative fashion. There is shared risk and shared reward when business outcomes are reached. Negotiations in this model are more integrative, with multiple integrated topics and risks to be considered and with a focus on collaborative problem solving. Negotiators have the potential to make tradeoffs across issues and create value as opposed to value exchange that we see in the other models.
At this point, I think an example might be helpful.
The supplier contribution is clear; deliver pens within a set timeframe, meeting a clear and fixed quality criteria (let’s say the pens have to be blue). It’s unlikely you expect the pen supplier to improve high level business objectives like employee satisfaction or increase productivity by having smooth pens that reduce the timescale for handwriting notes. As such, the supplier contribution is not only clear, it is fixed and concrete.
Now for the reward, you could be innovative and ask to pay your pen supplier based on the satisfaction of employees, but as decided above, it’s unlikely this is a contribution that will effect employee satisfaction, so why link payment terms to it. Inspecting further, there is really only one reward that makes sense based on the fixed and concrete supplier contribution – a payment per set of pens where price is optimized for both sides. This is a traditional purchasing sourcing agreement.
What many don’t fully appreciate is that this traditional model has developed because of the risk assessment component. In the case of goods purchasing, the service objectives are typically fixed and concrete. Similarly, the exact efforts and resources the supplier has to put in to realize these objectives are known up front. In other words there is virtually no risk of a mismatch in understanding between what drives supplier profits and what drives business value. As a result, an agreement forms that allows each side to focus on their main value driver – supplier focusses on price for their unit of output and the business focusses on their requirements for an agreeable cost. Both sides are therefore aligned on their sourcing model; a transactional model with fixed money for fixed output. In a transactional model the supplier is rewarded for every transaction (per unit, per mile, per hour, per minute, etc.). The more transactions the more the supplier gets paid. Consequently, suppliers under this model typically are not inclined to reduce the number of transactions.
Now take the example of a new software product to be developed
It’s immediately obvious that the risk of mismatch is very high between what the supplier of a new software solution thinks they should do – contribute – to meet ambiguous business service objectives (say a user friendly web based app for ordering products quickly and securely).
In situations where the contribution is unclear or indirect, with a high risk of a mismatch between the supplier’s perception of contribution and the client’s business expectations, a model where the supplier is paid per transaction is less appropriate. Alternatively an outcome based model where the supplier is rewarded on it’s contribution to business objectives may not be acceptable for the supplier because it puts all the risk in his court. To get around this conflict of interest many companies end in a transactional T&M agreement for this type of scenario. This however assumes all risks and unknowns are controlled by the client, while in reality, suppliers have the ability to address many of the unknown risks in such a service scenario and would be better incentivized to do this using an outcome based agile framework agreement(see our article on Agile contracts)
Conclusion
Simply put, each of the sourcing models works and no one model is better than the other. The key is to know when to use the right model for the right situation as each serves a different purpose and will garner different results and behaviors from your suppliers.
In a nutshell the correct sourcing model should be determined based on, aligning the business value (expected contribution) with the supplier interests (rewards that drive profit and incentives contribution) taking into account the reality of the risk profile between supplier activity and satisfactory contribution. This means that the clarity of business vision on objectives and outcomes – to both parties – is a key factor determining the sourcing model. If a business is unclear on what contribution they really desire and are not able to be honest in terms of the contribution truly contracted, sourcing is difficult to make successful. Also, if an inappropriate reward model is chosen that assumes supplier ownership of risk that is not in their control, businesses should expect to be disappointed, either with results, or with high costs.
To leave you with a few pragmatic rules to follow, below is a set of guidelines that will work in most situations and ensure you’re applying incentives that drive risk reduction (and better results)
- If most unknowns and risks (such as technical knowledge, internal process coordination, etc…) can be controlled by your supplier, DO NOT use a transactional model with a price per resource. Instead go for a more sophisticated model like output or outcome based.
- If there are very few risks and unknowns between supplier activities and realized business value (expected contribution), then use an output based model with a price per (semi) product of service./li>
- If there are few or well controlled supplier risks between supplier activities and expected contribution of higher business value, aim for a fixed price for contribution (ie: business outcome, not contribution unit of output)
- If risk profile is high and many risks are controlled by the business, work towards a transparent agile framework or use transactional T&M with appropriate incentive mechanisms.
Although an individual involved in the sourcing initiative can conduct the assessment of picking the right model, we suggest you think of it as a team approach that consists of a cross-functional group of subject matter experts and business users. Key suppliers can also provide valuable insight as they will provide there point of view. The various perspectives will help you create a more accurate assessment of the appropriate sourcing model to use.
For more information on the risk assessment and the questions to ask, selecting and structuring the right sourcing model for your business or to understand agile frameworks in more detail, please contact us.
