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Incentive Clauses in Contracts

Author(s):

Donald L. Woods, J.D., C.P.M.
Donald L. Woods, J.D., C.P.M., CEO, International Consulting & Contracting, Las Vegas, NV 89117, 702-254-6606, www.donwoods.com, dlw@anv.net

84th Annual International Conference Proceedings - 1999 

Abstract. Will incentive clauses result in improved quality goods and services with on time deliveries and excellent customer service? The purchasing professional must anticipate and be able to identify the pitfalls of utilizing contract incentive clauses.

Introduction. Incentive clauses or contract bonus wording conjure up images of a dangling carrot in front of an eager horse, and certainly the predecessors to this concept have been around for decades. Similar models show up in management salary negotiations, construction projects, and there is even a form of consulting wherein the provider is only paid a fee base upon a percent of the amount saved in auditing transportation costs, utility invoices, and other similar overhead costs.

History aside, today's purchasing and supply professionals must address the problem of inserting the clause into agreements for supplies and services. If a professional purchaser is going to include this concept in his or her arsenal of contracting tools, then he or she should be aware of issues such as source of funds, criteria, reasonableness of incentives, and contract wording.

Who Wants Incentives? Internally the suggestion for providing a bonus normally comes from a person without much experience with the nuances of the concept but has a great deal of ownership in the project at hand. To that using department or upper management representative, the idea of a reward for obtaining the desired results seems to be a win-win situation.

There are agreements that use incentives as the only consideration available to the provider. These are sometimes referred to as "percentage" or "shared savings" agreements that normally can be proposed by external specialists. Some examples are freight and utility bill auditing, operation costs reduction, and locating funds or resources such as grants.

Contractors and suppliers may feel that it is only fair to have a bonus clause, especially when there is a liquidated damages clause in the agreement pertaining to the ramificaitons if they exceed the requirements set forth in the written contract. While one purchaser might consider the incentive clause as a "guarantee" for the standard of service specified, the professional purchaser should proceed with caution.

Kinds of Incentives. The most common types of incentives are the express and the implied clauses found in contract documents. By "express" I mean the wording in the contract specifically addresses the description and amount of the incentive; whereas, the "implied" provides an inference to the supplier that if certain standards are met the supplier will benefit. For example: An annual contract with five, one-year renewable options infers that as long as the contractor is meeting or exceeding expectations, the contract will be extended annually.

Incentive clauses may also be classified as "negative, punishing or penalizing" for undesired acts; or as "positive", which rewards exceptional behavior. Examples of the negative would include: liquidated damages, withholding payments, promise to or actual blackballing, and threats or actions to invoke the breach clause. Positive incentives include the bonus (more money), share of savings, longer terms and in-kind services and trade-offs.

Source of Funds. Whenever there is an incentive clause, the purchaser must make sure there are funds available to cover any possible incentive reward. Preferably this extra money should be included in the contract or purchase order. The catch is that the owner or board of directors (private sector) or the elected officials (public sector) may view these extra funds as a waste of assets. Therefore, top management support must be secured in advance. A rebuttal to this based upon the improvement of the provider's quality, customer service, faster delivery or other such measurable goals is arguably already required by the agreement. The purchasing official must rely on emphasizing the benefits to the company or entity to garner acquiescence to the program.

Ideally, it would be better to have the parties find ways within the agreement to save costs and then let the supplier share in a percentage of the savings. But this, too, can create suspicion about the pricing of the contract.

Criteria. Is there really a benefit to the payor for the supplier reaching that goal? Take delivery time for example:

  • How and who determined the specified delivery time?
  • How and who will do the measurements, calculations or decision?
  • How and who has the authority to approve that delivery time and its enforcement?
  • What is the true value of the product being available sooner?
  • Is there an opportunity for collusion or unfair influence on the outcome by one of the parties?
  • Is a monetary incentive really necessary to obtain this goal?

With the contractor already bound by specific terms in a contract, it might be difficult to support a payment for a "desirable" result. And at contract formation, there may have been a misconception, or lack of attention, so that the goal was too lax and therefore guaranteed the contractor/supplier the extra funds.

Reasonableness of Incentives. The Uniform Commercial Code and contract case law may lack detailed treatises on this subject, but one theme is reoccurring: "The value of an incentive must be reasonably related to the value of the benefit to the other party." And just like the reasonableness in the liquidated damages clause, this should be measured at the time the contract was entered into. This means that both parties should have qualified experts prepare the measurements as well as amounts of compensation to be earned via the incentive clause. Otherwise, the courts may decide the incentive is not reasonable and rule that the clause is not enforceable.

Contract Wording. If an agreement has a liquidated damages clause, it does not mean that the parties necessarily have to have a corresponding incentive clause. In fact, no incentive clause is even necessary. And remember that the courts abhor the word "penalty" and will normally refuse to enforce those clauses in a contract. Unlike a penalty, liquidated damages are defined as predetermined, reasonable damages agreed to by the parties, at the time the agreement is entered into, to compensate a party for damages due to a breach, in situations where it would have been difficult to calculate actual damages.

Incentive Clause Case Study. In one recent case, an organization provided an incentive clause within their contract for a construction service provider. The contract was for the completion of an entire project, but the incentive clause applied only to the finishing of a particular part of the project. The incentive clause allowed for a payment of an extra $1,000 per day that the said portion was finished early, but the liquidated damage clause for not completing the project was only $100 per day. This contractor was able to complete the specified portion early, without finishing the project on time, and still make a profit after deducting the liquidated damages. This illustrates the importance of indicating all relevant contract and time frames within a contract and the incentive clause.

REFERENCES

Woods, Donald L., J.D., C.P.M., "Incentive Clause Caution", Purchasing Today®, October 1998 (Summary of Potential Problems with Bonus Clauses).

Pye, Carolyn, "Putting Performance on the Line", Purchasing Today®, May 1997, p. 47 (Supplier Bonuses for Improved Services)

Pye, Carolyn, "Blazing the Trail for Bonuses", Purchasing Today®, January 1996, pp. 28-30 (Internal Bonuses for Cost Savings).

Incentive Clauses-NAPM 1999 Course Outline

  1. History of incentive/bonus clauses
    1. Romans
    2. Construction
    3. Federal contracts
  2. How they arise
    1. User
    2. Contractor (especially when there are liquidated damages)
    3. Buyer
    4. External proposer
      1. Shipping
      2. Utilities
      3. Grants
  3. Kinds of incentives - Express/Implied
    1. Negative
      1. Liquidated damages
      2. Breach of contract
      3. Withholding payment
  4. Positive
    1. More money
    2. Share of savings (also % of grants)
    3. In kind services
    4. Longer term
  5. Issues
    1. Source of funds
    2. Criteria for activities
      1. Who determines
      2. Who measures
      3. What is true value of compliance?
      4. Who is ultimately responsible?
      5. Opportunity for collusion
    3. Reasonableness
      1. Pre-Bid
      2. during negotiations
    4. Contract wording

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