May 2016

How to make a supply agreement effective through clear KPIs and SLAs

Key Performance Indicators* (KPIs) and Service Level Agreements** (SLAs) are common features in long-term supply or service agreements. After all, without them, procurement’s best efforts at selecting preferred suppliers and negotiating a great price is likely to come undone.

But getting suppliers to agree to a meaningful SLA with effective KPIs, isn’t always easy. So here are a few things you should always keep in mind if you want your KPIs and SLAs to work.

Make your KPIs clear

An effective KPI always answers four key questions:

1.  What is being measured?

2.  Who is measuring it?

3.  At what interval is it being measured?

4.  How frequently is the information being reported?

We recently reviewed a supply agreement which included a KPI expressed as: ‘DIFOT – 95%’.

DIFOT means ‘delivery in full on time’ and is a KPI metric often used in supply agreements. However, it was not clear in the supply agreement what constituted a delivery in full and on time, how the DIFOT would be calculated and at what interval it would be measured. We amended the SLA to make it clear that:

  • A delivery would only be made ‘in full on time’ if:
    • products were delivered within two working days before or after the date specified in the order;

    • the quantity delivered was the quantity set out in the order, plus or minus 5%;

    • the product was delivered with all relevant documentation (including quality inspection certificates and a delivery docket), and

    • the product met the agreed specification.

  • The metric would be measured each month across the parameters in paragraph 1 above, based on the delivery date specified in the orders (or another agreed date) and the actual delivery date, and the number of products ordered.

To remove any ambiguity around what level of service was required and how the KPI was measured, we also included a formula to show how DIFOT would be calculated.

Use your KPIs to drive performance

KPIs can act as a ‘stick’ to keep your suppliers honest and accountable, so long as you use metrics that are easy to measure and calculate.

That said, don’t just opt for those metrics most easily measured. KPIs will drive behaviour, so carefully consider which behaviours you want them to drive. For instance, in outsourcing arrangements, your KPIs could be around customer satisfaction, or the response time to requests or queries, or they might be around achieving savings.

Once you’ve determined your KPIs make sure you have appropriate systems in place to measure and report on them.

Figure out the consequences for not meeting a KPI

In some supply agreements the SLA may be non-binding. In others, a failure to comply with the KPIs may just lead to a review followed by a future plan to mitigate the breach. In these cases, the SLA is used as an aspirational document, but has no real teeth.

Most suppliers will not agree to a binding SLA unless they have to: for instance, where it is the market or industry norm, or they need a competitive edge. But an SLA needs teeth to be truly effective.

When you’re determining the consequences of not meeting a KPI, think of:

•    How many infringements before the consequence is triggered?

The number of infringements required to trigger a consequence should depend on the goods and services being supplied, the KPI being measured, and the effect non-compliance has. In some cases, one infringement should be enough to trigger consequences. In other cases, it may require several instances of non-compliance.

One way to give a supplier some leeway is to trigger a consequence only when they fail to meet a KPI for two consecutive months, or for three out of six months. Another way is to express a metric so that it only needs to be met 80% or 90% of the time.

Be creative and push for a trigger that will drive the best performance.

•    Will the remedy be service credits, termination or both?

Councils generally use two common remedies for breaching a KPI:

Service credits, which let you deduct amounts from any fees payable to the supplier if they don’t meet KPIs.

If you choose to use service credits, make sure they’re high enough to act as an incentive to the supplier but not so high that failing to comply will make the contract unprofitable and demotivate them. We usually suggest considering an overall cap on the amount of service credits that can apply in any month or year.

Suppliers tend to prefer service credits as a consequence for not meeting KPIs. However, you need to always be mindful that a service credit should be sufficient to reimburse you for any loss. If they’re not, you should also have the right to claim damages.

You should also avoid positioning service credits as a penalty: in some jurisdictions, such as NSW, penalties are unenforceable. Instead position service credits as either:

  • a price adjustment (reflecting the reduced value of the goods or services), with the council retaining the right to seek damages for the breach, or

  • liquidated damages, and the sole financial remedy available to council (although you should still retain the right to terminate if the failure is severe enough).

Termination is another common remedy. It’s often appropriate in long-term arrangements where the supplier repeatedly fails to meet the service levels or where the KPI is critical to the project. But it will be heavy-handed and inappropriate for many breaches, for instance:

  • if the KPI is a ‘soft’ requirement that is not critical to council; or

  • if the supplier fails to meet a KPI on only one occasion.

In our experience, the best approach is to include both service credits and the right to terminate in some circumstances. But you will need to make sure the service credits, and the triggers for activating the consequence, are set at the right level. 

Your checklist for negotiating KPIs

Finally, when negotiating a supply agreement you should always think about 7 key questions:

  1. What KPIs will drive the outcome council expects?

  2. Are KPIs clearly defined and can they be easily measured?

  3. How often should performance against KPIs be reported?

  4. How many infringements should be tolerated before a consequence is triggered?

  5. What is an appropriate consequence?

  6. If service credits are used, will they adequately compensate council for loss suffered? Or does council need to retain the right to claim damages?

  7. Will it incentivise the supplier and drive the behaviour council expects?   

Having an open discussion with suppliers about each of these things will help you get the best out of them. They will understand what is expected and why – and you will be able to provide a better service to your community.

Author: Michael Cossetto

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