Maximising the value of commercial relationships

Implementing the UK’s Strategic Defence and Security Review and easing the budget deficit will require negotiation and re-negotiation of some key defence contracts. It is essential that the resulting agreements incorporate mechanisms to drive the right behaviours, within both the UK Ministry of Defence and its suppliers so that outcomes may be delivered at the best achievable value for money. Effective incentivisation mechanisms are key to achieving this.

This is not easy. Incentives act and interact in different ways for different organisations, teams and individuals, which can result in contracts that reward the wrong behaviours.

Developing effective incentivisation requires a structured approach that takes account of the outcomes to be delivered, the business drivers, an analysis of incentive interactions and practical management measures.

Understand the desired outcomes

In any commercial relationship, both parties will seek to derive the maximum possible value which is enabled by the mechanism(s) in the deal. It is essential that the design of an agreement is founded on a clear definition of all of the required outcomes (or benefits) that are required and a good understanding of the stated and likely behaviours that will deliver them.

Fundamentally, the desired outcomes should be derived from the organisation’s commercial strategy and business context. For example, a defence contractor might gain maximum commercial advantage from developing products that can be exported elsewhere, rather than developing a highly bespoke product for one national customer. For such a customer, agreeing outcomes which support the contractor’s exporting aims, will keep the cost down. However, if a world-leading capability is needed few countries are likely to be able to afford it, driving the best value for money solution and an attractive investment opportunity will require different incentives.

Identify the most appropriate commercial levers 

Business drivers vary by organisation, even in terms of basic measures such as the balance between short-term margin versus long-term growth. Identifying appropriate commercial levers will require analysis of the specific business model. A major pharmaceutical company developing an outsourced service contract gained critical insights when analysing a potential vendor’s proposal by identifying the underlying business model. As a result, some key assumptions were uncovered and discussed, which improved the vendor’s price and resulted in a more balanced apportionment of risk. 

Consider how incentives interact  

Effective incentivisation mechanisms include commercial levers that reflect the relative importance of the desired outcomes. System dynamics modelling (whereby dynamics are plotted to show how they interact) can help identify the most effective commercial levers for incentivising each objective, whilst highlighting any unintended consequences. Furthermore, through quantification of such models, the relative weighting to be applied to commercial levers can be assessed with some degree of confidence. For a mobile telecommunications operator, such modelling revealed that five fundamental KPIs drove their business. Such insight helped inform a network service contract, which was based on these key drivers and provided the focus for management effort.

Deliver value through a structured approach to incentivisation design

Taking a logical approach to the design of incentivisation mechanisms will maximise the likelihood of the resulting deal driving the behaviours that will, assuming at least as much energy and focus is applied to management of the agreement, realise the desired outcomes.