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Many contracts for services include penalties. These penalties are intended to be applied if the service provider fails to perform to the agreed performance or service levels.

It is unfortunately true that many customers and their providers spend a great deal of time and money on building sophisticated contracts with layered penalties ... which are totally ineffective. Often, poor performance persists, with the provider continually failing to meet the required service levels and the customer continually withholding payments under the penalty clauses. And nothing happening to resolve the problem. How can this happen?

Before we get into that, let's look at penalty clauses and how they are written into contracts.

In New Zealand you cannot include penalty clauses, as such, into a contract. You have to express any such clause in terms of "damages". The reason is that NZ law, in general, is based upon the premise that, if one party breaches the law in respect of another, the first party is not liable to the second unless the second has either suffered actual damage or been exposed to potential damage. This applies in legislation such as the Privacy Act: someone else may breach the Act in terms of their revelation of personal data about me, but I cannot take action against them unless I have suffered damage as a result. If the revelation does not cause me actual or potential damage, then there's nothing much that I can do about it.

You should check if the law in your country is founded upon the same principle.

You should also check with a lawyer that what I've said is correct.

As a result of this, you cannot put penalty clauses into contracts, but you can describe instances where damage will occur to your business as a result of the provider's failure to perform, and you can set a value for these damages, and you can require the provider to pay you these damages if it does fail to perform.

Sometimes this works well; sometimes it fails. This Topic will look at how contracts deal with these "liquidated damages".

Limits

Liquidated damages are often specified with limits. Sometimes the limit can be a money amount. Sometimes it can be the price of the service. So, if service levels get down to a certain point, the customer pays nothing. This may seem like a good incentive for high performance, but it can often turn out to be little incentive at all. Consider the following situation.

I am providing a service to you. We have set the damages at 25% of the price for every 5% that I fail to deliver. If my service is 100%, you pay me 100%. If it's 95%, you pay 75%. By the time my service level reaches 80%, you pay me nothing. So (you may think), there's a strong incentive for me to keep my service levels high.

But what if I'm struggling to provide 80% of the expected service level? In that case it won't matter to me whether I give you 80% or 75% or 70%. You won't be paying me anything anyway. So why should I care, until you terminate the contract on the grounds of my continued inability to meet the required service levels? Even then, it might be a relief to have you off my back. Maybe my lack of service to you is caused by me taking on a newer, bigger, richer customer than you, so I don't care if you terminate.

Value

The amount of damages given in the contract may not be the true amount of damage that you suffer. Sometimes it won't matter if you don't get the service provided to the agreed levels. Sometimes it will hurt your business a lot. If you have "blanket" clauses on damages as a result of non-performance, then you won't be getting the provider to focus on those areas that need fixing most.

A possible solution

Here's a possible answer to the problem. I'm not saying that this answer will work for you nor that it will work every time. I never do say that. I do say that it's another useful technique to have at your disposal, that you can consider for use. I do say that you should always examine your options rather than taking the path that is dictated by tradition or policy ... or a provider's standard contract.

First, try to find out what your service provider's gross margin is. If you are outsourcing a major service to a major provider and you are a major customer, then you should conduct a due diligence of the provider. So you'll know its gross margin. The provider will also do a due diligence on you, so it will know the real value of service to you. You can then work together, on a partnering basis, to make the best decisions for both of you. If you're a small customer dealing with a major provider, then a full due diligence is inappropriate, so you'll have to guess what the provider's gross margin is. Let me help you with your guess: it will probably be between 40% and 60% of the price.

Now, before you start saying that that's outrageous and bring all your services back in-house, consider the provider's situation. The gross margin (which is revenue less costs) is needed for the contingency planning that you want the provider to have, for the future expansion that you want the provide to have, and for the ongoing investment in technology, tools and techniques that you want the provider to have. Consider what your own gross margin would be if you were a service provider.

As a rough guide, assume that the bigger the provider, the bigger the margin. Small niche contractors may have a gross margin of 40%; the major international outsourcers will be at 60%, and maybe more.

As it happens, if a provider's gross margin is at the high end, then the leverage that a customer can exert is greater.

You don't have "damages" or "penalties" or any of that stuff. You have incentives. That is, instead of paying the full price for a service and then clawing back some part of it if performance is bad, you pay a base price for a service and then add an incentive payment if performance is good.

Here are some tips for making it work.

1. Set the base level for a service at the minimum level you can tolerate before the service has a significant negative impact on your business. If you won't start to feel pain until it gets to 70%, then set the base level at 75%. You make still continue to pay the base price if the service level drops to 70% or 65% or even lower. The base level simply means the minimum level that you will expect befoe it's worth the provider providing the service.
2. Set the base price, that you pay for the base level service, at the provider's costs. That is, at the base level you don't pay any of the provider's gross margin. If you know the provider's true costs (through a due dilifence), use those. If you don't, take 40% to 60% off the provider's standard prices for the service.
3. Set a scale for incentive payments based on added value. (This is one of the few times when the term "added value" actually means something.) If the base level for the service is 75% and getting 80% won't be much better, then pay a low incentive for achieving 80%. If the greatest value to you is achieved if the service level is 95% rather than 90% of the agreed service level target, then pay the greatest incentive for achieving 95% rather than 90%.

Here are some features of this approach.

1. All of the individual services provided can be separated out, and base service levels, base prices and incentive scales set for each. If a provider fails to meet the full expected service levels for any individual service, then both the customer and the provider will rapidly become aware of the effects and their cause.
2. If the provider doesn't reach the base level of service, it just gets paid the base price. It covers its costs, but nothing else. It won't want this to go on for long. Major international providers have their home office to report to, and they will have specific gross margins to realize. If they don't realize them, then the home office will start asking questions. Smaller service providers will go out of business.
3. The process of working through all these issues with a service provider can provide both of you with some useful insights in both your businesses. The customer should learn what levels of what services are most important to it, beacuse those are the service levels that it will pay the greatest incentive to achieve. The provider should also learn what is most important to its customers and be prepared to make investments targeted at those services and their service levels.