Perverse Incentives in Outsourcing Agreements

In Vested Outsourcing, Kate Vitasek and co-authors Mike Ledyard and Karl Manrodt outline the ten ailments of traditional outsource relationships. Number three on the list is the Activity Trap, which they describe as follows:

Traditionally, companies that purchase outsourced services use a transaction-based model. Under that model, the service provider is paid for every transaction — whether it is needed or not. Businesses are in the business to make money; outsource providers are no different. The more transactions performed, the more money they make. There is no incentive for the outsource provider to reduce the number of non-value-added transactions, because such a reduction would result in lower revenue.

The only incentive that often exists are perverse incentives, which the authors illustrate with this example:

Nineteenth-century paleontologists traveling to China used to pay peasants for each fragment of dinosaur bone (dinosaur fossils) they they produced. They later discovered that peasants dug up the bones and then smashed them to maximize their payments.

I was reminded of that “smashing of dinosaur bones” story when I read an article in Monday’s Wall Street Journal about Progress Rail Services (a subsidiary of Caterpillar) that inspects and repairs railcars at ports for clients such Union Pacific and BNSF. As Caterpillar revealed in a regulatory filing last November, The U.S. Attorney for the Central District of California is investigating the company for allegations that “Progress Rail conducted unnecessary or improper rail car inspections and that it failed to properly dispose of equipment, parts, tools and other items.”

The WSJ article shed some light on the investigation, based on interviews the Journal conducted with current and former employees. Here are some excerpts:

Some workers have resorted to smashing brake parts with hammers, gouging wheels with chisels or using chains to yank handles loose, according to current and former employees.

In a practice called “green repairs,” they added, workers at times have replaced parts that weren’t broken and hid the old parts in their cars out of sight of auditors. One employee said he and others sometimes threw parts into the ocean.

The article doesn’t provide any details about the structure of Progress Rail Services’ agreements with its clients, but based on the following details, it seems like they suffer from the Activity Trap and perverse incentives (emphasis mine):

Even so, they said, car men [workers that conduct the inspections] are under pressure to identify repair work to be done. The quickest way to do so, they said, was to smash something or to remove a bolt or other part and report it as missing.

They weren’t instructed to do that, the workers said. But they added that some managers made clear the workers would be replaced if they didn’t produce enough repair revenue.

Car men are expected to justify their hourly pay “and then some,” this worker said. “If you find no defects, it’s a bad night,” he added, and that creates a temptation to “break something that’s not broken.”

Current and former employees interviewed said those who found large numbers of parts to replace didn’t receive extra pay, but they tended to be favored by the supervisors and sometimes honored with employee-of-the-month recognition.

If you haven’t in a while, review your outsourcing agreements this week, specifically those with your strategic partners. Are there any perverse incentives in your outsourcing agreements? Any disincentives for your service providers to reduce transactions and simplify processes? Are you enabling the temptation to “smash dinosaur bones” in your outsourced operations?

Comments

  1. Adrian

    GREAT example of the Activity Trap in action and how it drives perverse incentives in outsourcing! Thank you for sharing.

    Your readers might be interested in the Univ of Tennessee’s latest white paper on Unpacking Pricing Models for some examples of more advanced pricing models create a more balanced approach to drive a true win-win economics. It’s obvious to see that transaction based pricing model can really drive bad behaviors!

    I am happy to share for you to post on your site – or your readers can download it from our research library (access it at http://www.vestedway.com) All of our white papers are open source/shareware.

    Kate

  2. A transactional model per se is not necessarily bad unless the supplier has the power to easily and surreptitiously inflate transactions (just like your dinosaur fossil example). That is why clients need other metrics in place to measure their suppliers’ cost performance along with incentives to lower costs and/or transacations (*if* the supplier has the power to reduce transactions). Performing an occasional supplier audit wouldn’t hurt either. 🙂

    In the dinosaur example, paleontologists should have paid on weight.

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