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Contract Theory: What Can Procurement Learn?


21-Oct-16 09:35
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"Contracts are really fundamental - we see them everywhere in society," said Per Stromberg, chairman of the Economic Sciences Nobel Prize Committee, shortly after Harvard’s Oliver Hart and MIT’s Bengt Holmström were awarded the prize for their work on contract theory.

 

It is a statement that certainly rings true for procurement. So, what did these professors find in their research and what can procurement learn from it?

 

Performance targets: Holmström looked at how employee contracts were currently structured and whether they were effective in motivating employees and improving productivity. He suggested that contracts should structure compensation based on all outcomes that can potentially provide information about actions that have been taken.

 

Holmström concluded that performance should also be considered in comparison to the broader market, rather than simply in relation to previous internal targets.

 

This suggests that, when setting targets, procurement should look at the performance of competitors.

 

Key Performance Indicators: Holmström co-authored a paper in 1991 entitled ’Multi-Task Principal-Agent Problems: Incentive Contracts, Asset Ownership and Job Design’, in which he explored employee compensation schemes. Employees, Holmström argued, have traditionally been measured on simple criterias, which tend to distort how they spend their time and can lead to important tasks being neglected.

 

This resource misalignment is something that procurement functions need to acknowledge when developing KPIs for their teams. Such indicators should be carefully chosen to incentivise performance across all procurement activities.

 

Holmström also suggested that businesses should actually consider increasing fixed salaries, rather than compensate employees through high reward performance-based bonuses. He argued that this can lead to a more balanced allocation of resources.

 

It is also worth the function thinking about how this could be extended to suppliers and what that might mean in terms of performance and cash flow.

 

Asset ownership: One of the central conclusions Hart developed was that the business which owns an asset has stronger bargaining power, motivating them to invest, and that consequently assets should be owned by the party whose investment is more important.

 

“When we write contracts with other parties, there are inevitably details that we would have liked to have in those contracts, which were not included,” said Hart’s colleague Eric Maskin, Adams University Professor and 2007 recipient of the economics Nobel, in an interview with the Harvard Gazette about Hart’s work. “And this means that ownership becomes important because, in the end, it’s the owner who decides how assets will be used.”

 

Hart concluded that synergistic assets, those which work together to produce an enhanced result, are best owned by a single operator, which for procurement would have significant implications for outsourcing.

This article is a piece of independent writing by a member of Procurement Leaders’ content team.


Alex Johnston by Alex Johnston

Tags: Blog
 
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