Addressing value, timing, and ownership arbitrage:
In our experience, outcome-based commercial models need to address three types of arbitrage:
- Value arbitrage: Buyers and service providers often define value and where it comes from differently. A buyer can have multiple sources of value, including cost, cash flow, growth, customer satisfaction, and speed, whereas a provider typically has only one source of value: to reduce the cost of delivering its services, sharing the rewards with the buyer, and getting compensated for the outcomes delivered
- Timing arbitrage: For buyers, the benefits and costs realized do not occur at the same time—there is a lag between when the cost is incurred and when the benefits are realized that needs to be understood and accounted for
- Ownership arbitrage: The benefits and costs are accounted for in different budget codes owned by different owners in the buyer’s organization, which creates ownership and incentive complexities
In our experience, there are specific reasons that lead to the above arbitrage; some of the important ones are listed below. To successfully implement the model, these challenges should be addressed between buyers and providers.
Misaligned on value definition
- The provider’s perceptions of which outcomes and metrics are important to the buyer differ from the buyer’s reality
- Softer, non-technical outcomes and metrics, like improved end-customer experiences and risk, are even more difficult to define and achieve alignment on
- There is often an over-emphasis on cost as a source of value, while ignoring the impact on revenue, cycle time, and agility
Limited detail in operating, measurement, and accountability
- Lack of detail to break down value into operating metrics and capability
- Lack of transparent measurement and reporting criteria
Static versus dynamic models
- Commercial models are not dynamic and do not adjust to the changing business landscape or outcomes that are important to the buyer
Commercial model granularity
- The lack of a clear, mathematical model that defines outcomes (with their relative importance), performance targets, operational metrics, and overall payouts
Misalignment of budget owner within the buyer
- Differences in budget ownership for benefits and costs, leading to ownership concerns
Windfall problem—the provider getting paid beyond permissible limits
- The need for proper thresholds and caps in the commercial model to not over-compensate the provider
Innovation and impact objectives
Successful implementation of alternate commercial models should resolve the above challenges, and be based on the target innovation levels and impact objectives for the buyer and provider to achieve (figure 1).
Most buyers and service providers first implement a hybrid commercial model—a combination of effort, output, and outcome-based models. Depending on the success, they then move towards a pure, outcome-based contract. In addition to the impact objectives and degree of innovation outlined in figure 1, there are important factors to consider, such as the flexibility of the buyer and provider to adapt as well as the level of trust that exists between the parties.