Balanced Scorecards in Commercial Contracts

The "Balanced Scorecard" concept has been around for some time, but widespread awareness of it as a business management tool originates from a 1996 Harvard Business Review article in which the authors proposed it as a more complete measurement of business performance than the purely financial measurements historically used.
Balanced Scorecards in Commercial Contracts

The basic idea is that by using a myopic focus on the detailed metrics (and giving each measurement equal weight), a business can loose sight of how well it is actually performing against its strategic objectives. The authors suggested that performance should be measured against four perspectives:

  1. Customer ("How do our customers view our performance?")
  2. Internal business process ("How well do we manage internal business processes to meet customer expectations?")
  3. Financial ("Are we creating value for shareholders?")
  4. Innovation & knowledge ("How well do we learn and improve what we do?")

Starting with the strategy (derived from a mission and vision) for the business function, strategic objectives can be devised and tactics to meet them, and then the measurements. Each measurement is given an appropriate weight based on its importance to achieving the objective and the objective itself.

What are Balanced Scorecards?

Like service levels, Balanced Scorecards (BSCs) measure performance. Service Level Agreements ("SLAs") take a purely tactical approach, focusing on numerous (upwards of 20 and sometimes as many as 100) specific performance criteria, for example, network uptime, IP packet transfer rates, application response time, average time to resolve faults). Failure to meet one service level may be grounds for complaint regardless of the impact on overall contract performance.

The BSC takes a more holistic approach, typically avoiding the kind of "technical" metrics historically used in SLAs. Instead, a smaller number of metrics are set that reflect the business objectives, and each is given a weight based on the parties' agreement as to its relative importance to overall service performance. These metrics are often measured both by surveys and by reference to more "objective" information (cost savings, efficiencies, etc.). Statistical methods can be used to gather the information and draw meaningful conclusions from it. Again, the emphasis is on structuring a holistic approach.

Why lawyers need to know about BSCs

The development of a BSC is very much business driven, but because lawyers must draft contract terms to accurately capture the intent and effect of utilising a BSC approach, it helps to understand the process of how a BSC is developed.

However, before the process is discussed it is useful if an example of a BSC being applied is considered.

Example of a BSC being used

Customer A engages Service Provider X to improve and maintain its e-commerce website application and infrastructure. Customer A's CIO presents a list of 45 individual specifications for how the website should operate under Supplier's X's management based on how the CIO has been managing the website, including network uptime, download speeds, expecting that those will be reflected in a SLA. Service Provider X proposes to the CEO that its performance during the initial 2 years of the agreement is measured on 4 metrics:

Metric Weight
% Increase in Customer A's website sales* 10%
% Increase in Customer A's website visit/sale ratio* 30%
% Improvement in end-user's "website experience" ratings* 30%
% Reduction in returns due to order-capture errors* 30%

*Assuming the parties can agree on acceptable baselines. The weighting should also take into account Supplier A's ability to influence the result.

Each of the 4 metrics is measured on a 0 to 100 scale at the end of each calendar quarter, multiplied by the weighting factor and totalled. If the score is below 20 Service Provider X will give Customer A 100% of the agreed maximum service credit for a quarter. Between 20 and 30, the Service Credits due are reduced rateably to 0. It should be noted that a feature could be added to provide Service Provider X an upside for exceeding a score of 30.

Sample Calculation Weight Score Weighted Score
% Increase in website sales* 10% 35 3.5
% Increase visit/sale ratio* 30% 45 13.5
% Improvement in end-users  "website experience" ratings* 30% 25 7.5
% Reduction in returns due to order-capture errors* 30% 14 4.2
Total Weighted (Balanced) Score - 28.7      

The BSC approach appeals to the CEO much more than a bevy of technical metrics (that he does not understand) because it focuses on the company's business objectives.

A BSC approach can be used either in place of or in addition to traditional SLAs. BSCs can also be used to measure the customer's performance of its obligations relating to the outsourcing services, and factor those results into the compensation model (for example, if the customer fails to meet its scores, the service provider gets relief on its scores).

BSCs can be used as a pure governance tool, to help manage the relationship, or they can be used as an incentive to the service provider aligned with the client's business priorities. In some cases the BSC provisions include a mechanism where the service provider puts a percentage of its fees at risk to the extent that metrics are not met. As mentioned above, bonuses could also be added to the extent that BSC goals are exceeded.

The best BSC will align the job performance objectives that apply to the customer executives responsible for overseeing the service provider relationship. By aligning those objectives, the service provider will more likely be seen as an ally than as a threat. It should be noted that the executives assigned to manage the service provider relationship are often the former managers of the business function(s) outsourced. They may have resisted the outsourcing, and without the alignment of incentives, could be a risk to success.

Benefits and risks

The BSC approach in outsourcing has three key benefits for both parties:

1.it aligns interests, which is likely to enhance the working relationship;

2.it allows the parties to focus on what is truly important rather than what is easily measured. It avoids the expensive (and resource consuming) tracking/reporting of numerous technical metrics that themselves do not measure the performance against business objectives; and

3.by aiming at a higher level, it provides both the service provider and the customer the flexibility to change and improve the service delivery without having to work with or renegotiate detailed metrics rendered irrelevant by changes in technology. This makes BSCs particularly well suited for transformational outsourcing arrangements. The BSC approach provides an incentive for the parties to continually improve the technology and business processes to achieve better business results as opposed to the SLA that "locks" a service provider into a way of providing the services because of the items that are measured.

There are two aspects of BSCs which can be challenging:

1.Developing a robust BSC that supports the business objectives and provides the proper incentive can take a significant effort on the part of both parties. If the customer does not perceive the value of the exercise in the first place ("We've always done it this way, so why change?"), the task is even more difficult. The key is getting the buy-in of the customer's senior management, and their continued active involvement.

2.Outsourcing agreements typically have terms of 5 to 10 years and business priorities are bound to change in that time. The parties must be committed to revisiting on a reasonable schedule (every 12 to 24 months) and reconfirming or changing the BSC metrics to ensure they remain relevant. This re-evaluation of the BSC should be part of the governance process for the relationship. There is a risk that a client will too often change "strategic" direction leading to frequent and drastic changes in BSC priorities that will cause too much disruption or uncertainty for the service provider. From a service provider's perspective, a customer's propensity to changes in strategic direction should be assessed before agreeing to a BSC approach.

Developing a BSC

The following issues should be considered when developing a BSC:

  • The BSC must have an owner (who is responsible for making things happen) and a sponsor (who provides the management impetus to keep things happening). The sponsor should be as senior as possible, whereas the owner must be able to take a hands-on approach. They should both work with the project team during the development of the BSC. Similarly, each metric and process should have an owner.
  • All metrics should be assessed against a target, although it may take some time before the latter can be reliably developed.
  • Statistical Process Analysis techniques should be used once the metrics have been set up and piloted for some time. This is to determine cause-and-effect relationships between the various metrics in the BSC, from which some of the targets may be refined.
  • The scorecards should be flexible enough for measures to address current, relatively short-term requirements to the extent necessary (this can be planned through 'seasonal metrics', for example, evaluation performance, client satisfaction survey score).
  • The scorecards should make use of existing measures and reporting mechanisms where appropriate (however, it is unlikely that all existing measures will be appropriate for the BSC), but should seek to tie them together into a single framework. The BSC should never just be a rollup or summary of current metrics.
  • The cost of obtaining metrics data should be justified by the 'value of knowing'. Where this cost is high, the benefits that could be obtained through re-deploying the resource elsewhere should also be evaluated as part of the cost of collection.
  • The BSC should not be set in stone. It is a dynamic tool that should be continuously enhanced, through improving the metrics on the scorecard and adapting it as the business unit refines its organisational goals.

Key points to remember when developing BSCs

  • Determine the BSC "Architecture": The BSC should be based on the strategic objectives for the business function(s) the service provider is supporting, and aligned with the interests of (and the relationships between) the service provider and the management of the business function(s) supported. It is critical that this framework is developed with and agreed to with the appropriate stakeholders.
  • Confirm the BSC architecture with the service provider and customer stakeholders: Prior to beginning the execution of the BSC process the following information must be gathered (or developed): (a) the service provider and customer strategies (including missions and visions); (b) reasons for outsourcing; (c) the service provider and customer stakeholder expectations; and (d) specific goals, strategic objectives and critical success factors.
  • Identify metrics: It is important to make the distinction between goal-based metric selection and simply listing the things that can be measured. The basic principle is that each organisation or team has a set of objectives it wants to achieve. There are Critical Success Factors (CSFs) necessary to achieve those objectives. Identifying the CSFs is the first step toward identifying specific metrics. CSFs may be behavioural patterns, processes or organisational characteristics critical to the attainment of an objective.
  • Define metrics, targets, process owners and frequency of collection: Every measure selected should be a part of a chain of cause and effect that represents the strategy. Every measure selected should ultimately be related to business value. The process owner for the metric is responsible for determining how to measure and improve the metric, as well as implementing and resourcing the process as necessary to collect and report the metric.
  • Assess the requirements for gathering metrics: The implementation and collection costs of each metric should be weighed against the 'value of knowing'. If the cost outweighs the benefit, other alternatives should be considered.
  • Identify linkages and cause & effect relationships: A BSC is intended to be an effective tool for communicating an organisation's strategy. To ensure this occurs, the parties need to identify and document the cause and effect relationships between critical success factors. Leading and lagging CSFs need to be identified and categorised to determine the cause and effect relationships for each one.
  • Implement the scorecard.
Balanced Scorecards in Commercial Contracts

by Dr Sam De Silva

Partner - Head of IT Law and Outsourcing Law, Penningtons Manches LLP

Dr Sam De Silva is a partner and the head of the IT and Outsourcing practice at leading UK law firm Penningtons Manches LLP. His main areas of practice are technology projects and the outsourcing of technology and business processes.  He has been published widely and speaks regularly on these topics and is Chair of the Law Society's Technology and Law Reference Group. Sam is also one of very few UK solicitors who is a Fellow of the Chartered Institute of Purchasing and Supply (FCIPS), Fellow of the British Computer Society (FBCS) and a Chartered IT Professional (CITP).  He is also an IT Law Accredited Member of the Society for Computers and Law.  

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