Carrot and Stick (Part 2)

In part 1 of this article we spoke about the 2 types of approaches to incentives; Approach 1 being negative incentives (stick) and Approach 2 being positive incentives (carrot). We also introduced a behaviour called loss aversion which describes how humans are keen to cut loss altogether since losses hurt twice as much as gain makes you feel good.

So why the debate? Based on this discussion the simple solution is to always use Approach 2. And while from a behavioural perspective this is true, what level of performance are we trying to deliver? Consider the simple payment curve in Figure 1 below.

 Approach 2 Payment Curve

Figure 1 – Simple PBC Payment Curve

Under Approach 2 the seller earns an increasing part of the Performance Fee as the delivered performance level increases. Simple. But the question is what performance level does the buyer need to run their business? For example, is it the performance level where the seller receives 100% of the Performance Fee? Or is it the performance level where the seller receives 75% of the Performance Fee? So which is it?

The reality is that unless a specific performance level is contracted then this decision is left to the seller on the assumption that the incremental amount of Performance Fee will incentivise them to deliver better performance. If the buyer desires performance significantly above the minimum performance level, then Approach 2 needs to be carefully considered.

While many of you reading this may believe this to be too harsh on the seller, having worked for many years on the behalf of the seller this is not a trivial question since the seller also needs this information when designing their contract solution. For example, the required level of performance drives the following questions; How many staff do I need? Where should I place my maintenance depot? What spares do I need and where? Etc.

This is even more important when undertaking a competitive approach to the market since it may entice some contractors to minimise the designed performance level in order to minimise the contract price thereby maximising the chance to win the contract. This is a false economy on both parts since in my experience minimal performance and minimal prices typically doesn’t lead to long-term successful contract relationship but rather continued disagreement and dispute.

In summary, regardless of whether you use Approach 1 or Approach 2, the key to success is clearly describing the performance level required by the buyer and ensuring that there are enough incentives to motivate seller behaviour.  So which Approach do you use and why?

This entry was posted in Basis of Payment, Definition, the Why and tagged , , , , . Bookmark the permalink.

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