Incentive-Compatible Compensation Schemes

Performance-based contracts or contracts for services are the basis for compen-sation of services rendered. The form a compencompen-sation scheme takes depends on the type of contract involved. Compensation schemes for both types of contract are described below (Picot and Ertsey 2004).

2.5.3.1 Compensation Based on a Contract with a Defined Result By signing a performance-based contract, the service provider undertakes to deliver a defined result with clearly specified characteristics in accordance with Fig. 2.16 Principal-agent relationship

agreed terms and conditions. So only the price remains to be set. There are two ways of doing this: The customer can either recompense the provider for the actual costs incurred plus some additional amount (‘‘cost-plus’’) or pay a fixed price.

With cost-plus contracts, the customer alone bears the project’s cost risk. The provider is in a position to report inflated costs, and even clauses stipulating the disclosure of cost information cannot rule this out completely. A cost-plus contract makes sense when the project specifications are incomplete and the provider is not able to estimate the production costs.

However, if one of these two conditions is not fulfilled, a fixed price agreement is advisable. Under an agreement of this kind, the customer pays a previously agreed fixed price at the end of the project. This means that the provider alone bears the projects’ cost risk. If the costs incurred by the provider are below the agreed price at the end of the project, the provider has realized an (additional) profit. But if the total project costs exceed the agreed price, its profit margin shrinks correspondingly and in the worst case, it might even make a loss. A fixed price certainly gives the provider an incentive to conduct the project efficiently.

At the same time, however, there is no motivation to pass on any savings to the customer. We will discuss methods of estimating costs and approaches to pricing custom software projects inSect. 3.3.4.

Both types of contract feature a completely one-sided risk situation, with only one of the two parties bearing all of the risk. This gives the other side leeway to act opportunistically. The model presented below describes the distribution of risk for cost-plus contracts. Let us assume that a provider receives compensation e. This comprises a fixed fee f_minand a certain share a of the difference between planned and actual costs ca– cp, where cprepresents the planned costs and cathe actual costs. The customer and the provider therefore share the excess costs. If c_a is below the contractually defined minimum c_min, then the provider still receives the minimum amount f_min—thereby realizing additional profit. But if c_aexceeds c_max, the provider still receives the agreed maximum amount f_max—and its profit margin sinks, or it may even make a loss. The compensation scheme, which limits risk for both parties, is as follows:

Figure2.17illustrates this compensation scheme with an example in which c_p and c_minboth amount to 80 monetary units (MUs).

Additional development costs up to a maximum of 120 MUs are contributed by both parties equally, i.e., for c_{a =}100 MUs, the provider receives 80 MUs plus 0.5 (100 MUs–80 MUs) = 90 MUs. Project costs in excess of 120 MUs are borne solely by the provider. If the project costs are below 80 MUs, the provider alone profits from the efficiencies achieved.

2.5.3.2 Compensation Based on a Contract for Services

Under a contract for services, the provider undertakes to perform a particular task such as programming or the provision of a service. If a fixed price is agreed, the provider has an incentive to work cost-effectively and may not focus sufficiently on the quality aspect—after all, it has only agreed to perform a task. This problem can be addressed by means of an incentive-compatible compensation scheme in which the fee is linked to the quality of work performed.

Let us refer to the provider’s performance (e.g. number of lines of code) as p_a. If p_ais below an agreed threshold p_min, the provider does not receive any fee—as a deterrent. In the interval [p_min; p_max], the service provider receives the minimum fee f_minand a share of the bonus b which is equal to f_max-f_min. If the performance is greater than p_max, the provider only receives the maximum fee f_max, so no provider will be motivated to achieve that. If the bonus paid in the interval [p_min; p_max] is to increase linearly with the performance, the overall fee f is calculated as follows:

f¼

0 where p_a\p_min

fminþ p_ap_min

p_maxp_minðfmax fminÞ where p_min p_a p_max

f_max where p_a[ p_max

8<

:

In practice, this depends on the ability to measure performance p_a in an objective way. For a software development project, this can be based on lines of code while for network services, service level agreements can be employed.

We will illustrate this scheme by way of a brief example. Let us assume that the performance of a software company is to be measured in lines of code (LoC).

Although this indicator is not ideal for various reasons, it can still give a rough idea of the provider’s performance and is used, for example, in models designed to estimate software development effort, such as COCOMO.

Fig. 2.17 Example compensation scheme based on a contract with a defined result

In our example, we assume that the contracted software company is supposed to develop at least 200 LoC and receive a fee of 200 MUs for 200 LoC. Up to 300 LoC, the fee increases linearly up to 400 MUs. Below 200 LoC, the software company receives no fee at all. Above 300 LoC, it always receives 400 MUs. The customer is therefore introducing two separate incentives: at least 200 LoC are required (e.g. to avoid jeopardizing the follow-on project) and up to 300 LoC would be very useful (reflected by the fee for each additional LoC in the interval [200;300] MUs. Figure2.18 gives an overview of this example.

To conclude, we would like once again to highlight the basic differences between the two compensation schemes presented. Both include the idea of sharing risk within given limits. But the crucial difference is the basis on which the fee is determined: for a contract with a defined outcome, this is the costs incurred by the provider, whereas for a contract for services, it is the provider’s performance.