Vendor Management Insider: Making the Most of Service Credits

Service-level credits and incentive models are important tools to help outsourcing clients increase business alignment and enforce service-level achievement. When executed effectively these tools drive the behavior of service providers and allow all parties to manage the relationship more effectively. But, skeptics remain.

Some clients we’ve spoken with say that, while the main purpose of service-level credits and incentive models is to get providers to focus on the right service levels and to drive the outsourcing relationships toward better business alignment, the current use of credits and incentive models is generally weak and ineffective.

This stems from a couple of core, fundamental problems, most notably poorly defined service-level credits add no value. Many service-credit models — in which suppliers pay back credits to clients for poor performance — are overly complex and difficult to manage. With weak service-level definitions, lack of service accountability, and insufficient measurement methods in place, these credit models completely fail in their original goal: to help IT leadership manage the quality of service providers.

Another typical issue we see is service-level incentive models serve primarily to mitigate the service provider’s risk. Service-level incentives — which are based on overachievement of all service levels — are often built on an “earn-back” model. In these models it is too easy for providers to earn incentive points, which they then use to compensate service-level credits. Forrester finds many outsourcing relationships in which providers have never paid service-level credits, although the service delivery quality is weak,
because they compensate for credit with easily achieved incentives.

It is the responsibility of the sourcing professional to find the right service levels to cover business objectives and to negotiate these models with an eye toward business goals. For this reason, service credit and incentive models should be discussed as early as possible in the vendor selection process (i.e., RFP). Sourcing professionals can improve their use of these tools by understanding the fundamental elements of credit and incentive models.

Clearly defined measurement methodologies and clear accountability from participating providers are the first steps in making service credits successful and avoiding disputes.

While clients are often committed to use of service-level credits as a way to increase the sustainability of service delivery quality, providers often don’t see the need for them. In many cases, when clients wish to apply service-level credits to a contract, providers try to mitigate the risk by defining only minimum service levels and/or introducing service-level incentive models to “earn-back” service credits. In our review of outsourcing contracts, we see several key elements in credit and incentive models:

• Correctly defined service levels are the foundations for success. Clearly defined measurement methodologies and clear accountability from participating providers are the first steps in making service credits successful and avoiding disputes. Every underlying service level of credit models needs to be focused on client’s business needs and/or should generate added value for the outsourcing relationship. In Forrester’s experience, far too many companies pass over this
  fundamental point when designing their incentive and credit models.

• Select the right model for your needs. The predominant service-level credit model takes the form of a charge-reduction, which reinforces the service provider’s commitment to the service level. We also see models that provide for a payment by the provider to be invoked when failure by the provider causes actual financial losses to the user’s business. In either case, it is up to the SVM professionals to find the right balance between service-level credits that address the fundamental, root causes of problems, yet are tactical enough not to damage the health of the outsourcing relationship. In either case, clientsshould not use service-level credits as a way to reduce monthly charges.

• Apply minimum service level only if agreed with the business. We often review contracts with different service-level targets: minimum service levels for service-level credits, “standard” service levels that reflect clients’ existing business requirements; and maximum service levels that are linked to service-level incentives. SVM professionals should avoid this complexity or at least discuss the differences between minimum and standard service levels carefully, with a tight focus on the business objectives. Minimum service levels must be agreed with the business, because it is the business that will typically feel the pain if the service level is not met.

• Integrate credit models into the contract exit strategy. Every service-credit model needs an escalation process to communicate the service-level violation to the next level of the vendor governance model — typically as a way to start the root-cause analysis and the improvement process. These escalation processes can be supported by a staged credit model linked to problem resolution, increasing credits after recurring violations in an agreed time period, and ends in a possible contract and/or service termination process for continuing problems.

Outsourcing clients who are seeking to create credit and incentive models need to walk a  fine line: they must keep the models as simple as possible, while also defining the model in enough detail to drive the desired behavior. In addition, either model needs to be easy to manage and seek to avoid escalations and dispute discussions.

Wolfgang Benkel is a Principal Analyst at Forrester Research, where he serves Sourcing & Vendor Management Professionals.