Tuesday, April 16, 2002

Righteous Contracts

Right"eous a. Doing that which is right; yielding to all their due; just; equitable.
[Webster’s Revised Unabridged Dictionary, 1913]

Righteous contracts. A good name for contracts whose purpose is to assure that the parties act in a just and equitable manner and yield to the other their due. Righteous contracts are those governing investments in specialized assets – assets which are very important to a business, but have no value anywhere else. For example, software developed specifically for a single company is a specialized asset, since it is useful only by the company for which it was developed. Agreements to develop specialized assets create a bilateral monopoly; that is, once the parties start working together, they have little option but to continue working together. This bilateral monopoly provides an ideal environment for opportunistic behavior on the part of both supplier and customer.

Thus the purpose of righteous contracts is to prevent opportunistic behavior, to keep one party from taking advantage of another when market forces are not in a position to do so. In a free market where there are several competent competitors, market forces control opportunism. This works for standard or commodity components, but not for specialized assets.

The traditional way to develop specialized assets has been to keep the work inside a vertical organization, where opportunism is controlled by administration. Inside a company, local optimization would presumably be prevented by someone positioned to arbitrate between departments for the overall good of the enterprise. Vertical integration allows a company to deal with uncertainty and change in a rapid and adaptive manner.

Recently, however, outsourcing has become common in many companies, for very good reasons. An outside company may have lower labor costs or more specialized experience in an area that is not one of the firms core competencies. The cost of producing a service or asset can be considerably lower in an outside company. Of course, there are transaction costs associated with outsourcing, and the total cost (production costs plus transaction costs) must be lower, or vertical integration would make more sense.

Transaction costs associated with outsourcing include the cost of selecting potential suppliers, negotiating and renegotiating agreements, monitoring and enforcing the agreement, billing and tracking payments. Transaction costs also include inventory and transportation above that needed for vertical integration. In addition, there are risks associated with outsourcing, which may result in additional costs. One cost would be that of diminished communication. For example, development of any kind usually requires intense communication between various technical specialties and target users. If distance or intellectual property issues reduce the communication, it will cost more to develop the asset and the results may suffer as well. In addition, moving a specialized skill outside the company may incur lost opportunity costs.

There are two types of contracts which are used for developing specialized assets – Contracts which are executed before the development is done by the supplier, and contracts which are executed after the supplier does the work. A contract executed before work is done is known as a before-the-fact (or ex ante) contract. There are two types of before-the-fact contracts – fixed price contracts and flexible (time-and-materials) contracts. Once these contracts are executed, they set up a bilateral monopoly, fraught with opportunities for exploitation on one side or the other. Therefore, the purpose of these contract is to set up control systems to prevent exploitation.

A contract executed after work is done is called an after-the-fact (or ex post) contract. Suppose a supplier develops a system that it thinks a customer will find valuable and then tries to sell the system. In this case, control comes after the fact; the supplier makes its own decisions, and it’s reward is based on the results. Of course this is a risky proposition, so the supplier has to hedge its bets. One way to do this is to sell the system to multiple customers, basically making it into a commodity product. But this doesn’t help a company that wants suppliers to develop proprietary components for them. In order to entice suppliers to develop specialized assets prior to a contract, a company usually sets up a sole source or favored source program. If a company treats its favored suppliers well, the suppliers develop confidence that their investments will be rewarded and continue to make investments.

On the surface, after-the-fact contracts may seem implausible for software development, but in fact, they are the best solution for contracting a development project. Moreover, the best kind of development processes to use inside a company are those that mimic after-the-fact contracts. How can this be? The explanation starts by understanding why before-the-fact contracts provide poor governance for development projects.

Fixed-Price Contracts
Let’s examine the most commonly used before-the-fact contract, the fixed price contract. A key motivator for fixed price contracts is the desire of a customer to transfer risk to the supplier. This may work for simple, well-defined problems, but it is inappropriate for wicked problems.[1] If the project is complex or uncertain, a fixed price contract transfers a very high risk to the supplier. If the supplier is not equipped to deal with this risk, it will come back to haunt the customer.

Risk should be born by the party best able to manage it. If a problem is technically complex, then the supplier is most likely to be in a position to manage it. If a problem is uncertain or changing, then the customer is in the best position to manage it. Transferring the risk for such problems to the supplier is not only unfair, it is also unwise. There is no such thing as a win-loose contract. If a supplier is trapped on the wrong side of a win-loose contract, the bilateral monopoly which has been formed will trap the customer as well. Both sides loose in the end.

Fixed price contracts do not usually lower cost, because there is always at least some risk in estimating the cost. If the supplier is competent, it will include this risk in the bid. If the supplier does not understand the complexity of the problem, it is likely to underbid. The process of selecting a supplier for a fixed-price contract has a tendency to favor the most optimistic (or the most desperate) supplier. Consequently, the supplier least likely to understand the project’s complexity is most likely to be selected. Thus fixed price contracts tend to select the supplier most likely to get in trouble.

Therefore it is quite common for the customer find a supplier unable to deliver on a fixed price contract. Because the customer no longer has the option to choose another supplier, they must often come to the rescue of the supplier. Alternatively, the supplier might be able to cover its loss, but most likely it will attempt to make the loss up through change orders which add more revenue to the contract. This leads the customer to aggressively avoid any change to the contract. Faced with no other way to recoup the loss, a supplier will be motivated to find ways to deliver less than the customer really wants, either by lowering the quality or reducing the features.

The customer using fixed price contracts to transfer responsibility and risk will often find both back on their plates in the end, and if so, they will be worse off because of it.

Flexible Contracts
“Customers should prefer flexible-price contracts to fixed-price contracts where it is cheaper for the customer to deal with uncertainty than it is for the contractor to do so or where the customer is more concerned with the ability of the contractor to provide a product that works than with price,” writes Fred Thompson in the Handbook of Public Administration. (Second Edition), Rabin, Hildreth, Miller, editors, New York: Marcel Dekker, Inc., 1998.

The flexible-price contract is designed to deal with uncertainty and complexity, but it does not do away with risk, it simply shifts it from the supplier to the customer. For example, after the DOD (U.S. Department of Defense) experienced some very high profile bailouts on fixed price contracts, it began to use more flexible-price contracts is situations where the government was better able to manage the risk. Of course, with the risk transferred to the customer, the supplier has little incentive to contain costs in a flexible-price contract, a point that did not escape contract negotiators at DOD. In order to protect the public interest, DOD perfected controls imposed on the supplier.

Controlling suppliers of flexible-price contracts evolved into a discipline called project management. The waterfall lifecycle grew out of military contracts, and an early focus of PMI (Project Management Institute) was DOD contracts. Companies with DOD contracts not only hire administrators to oversee compliance with contract requirements, they also add accountants to sort out allowable and unallowable costs. Flexible-price contracts invariably have high transaction costs, due to the high cost of control.

Controls Do Not Add Value
High transaction costs would be reasonable if they added value, but in fact, transaction costs are by definition non-value-adding costs. Fred Thompson (Ibid.) notes, “Controls contribute nothing of positive value; their singular purpose lies in helping us to avoid waste. To the extent that they do what they are supposed to do, they can generate substantial savings. But it must be recognized that controls are themselves very costly.”

One way to avoid the high cost of control in flexible-price contracts is not to use them. It may be better to do development internally, where it is easier to deal with uncertainty and respond to change. The question is, on what basis should an outsourcing decision be made? Thompson (Ibid.) counsels, “The choice of institutional design should depend upon minimizing the sum of production costs and transactions costs.” He also notes, “Vertical integration occurs because it permits transaction or control costs to be minimized.”

An interesting problem with this equation is that vertical integration does not always work to minimize control costs. In fact, many organizations find themselves using DOD-like project management controls internally. It seems incongruous that control mechanisms which add cost but not value, and which were invented to prevent opportunistic behavior, would come to dominate development in the very place where they should not be needed. If the reason to develop internally is to provide flexibility in the face of uncertainty, then costly, change-resistant control practices are inappropriate. Traditional project control practices (that freeze requirements, require approval for changes, and track tasks instead of features) have a tendency to create waste, not value, when used inside a company.

After-the-fact Contracts
Let’s assume for the sake of argument that the choice has been made to outsource a complex, specialized development effort. The next question is, how can transaction costs be reduced? In the manufacturing industry, this is done with after-the-fact contracts.

Despite the obvious risks, is not uncommon for suppliers to develop specialized components for a manufacturer prior to obtaining a contract. For example, 3M Optical Systems Division used to develop optically precise lenses for specialized automotive taillights. The reward was a one year contract for a specific model. Unfortunately, after the first year, the automotive company would invariably find a cheaper way to make a similar lens, and Optical Systems would loose the business before it had recovered its investment. The division eventually decided that after-the-fact contracts with Detroit automakers were not profitable and left the business.

There are ways to make after-the-fact contracts work better. Toyota awards contracts for an entire run of a model, and uses target costing to manage costs. Thus a supplier knows that if it wins the business, it can recover its investment, while the customer is confident that the supplier will work reduce costs in line with its economic requirements. In addition, the supplier understands that it will receive favored consideration for similar components in the future.

After-the-fact contracts require two elements to work: shared risk and trust. Toyota shares the risk with a component supplier by guaranteeing the business over the life of an model. Both parties agree to work together to try to meet a target cost profile over the life of the agreement. Note that meeting future target costs is neither guaranteed nor is it the sole responsibility of the supplier. In the best relationships, technical personnel from each company work freely together without worrying about proprietary information, both to meet target costs and to develop new components not yet subject to a contract.

If both parties are pleased with the results of the first contract, they develop trust and a good working relationship, and are more likely continue to do business together. The supplier is inclined to risk more in developing new components when it has developed confidence that the investment will pay off. This kind of relationship can achieve all of the benefits of both outsourcing and vertical integration combined.

But Software is Different…
You might be saying to yourself, this is fine if there is something to be manufactured and sold many times over, like a taillight, but in software we develop a system only once, it is complex and expensive, it is subject to many changes, and if it is not properly designed and executed, huge waste might result. Where is the parallel to THIS in manufacturing?

Consider the large and expensive metal dies which stamp out vehicle body panels. The cost of developing dies can account for half of a new model’s capital investment. Consequently, a great deal of time is spent in all automotive companies working to minimize the cost of these dies. The approach in Japan is distinctly different from that in the U.S., and dramatically more effective. The best Japanese companies develop stamping dies for half the cost and in half the time as their counterparts in the West. The resulting Japanese dies will be able to stamp out a body panel in 70% of the time needed by U.S. stamping operations.

From the classic book Product Development Performance by Clark and Fujimoto, Harvard Business School Press, 1991:
Japan firms use an ‘early design, early cut’ approach, while U.S. practice is essentially “wait to design,, wait to cut.”

Because it entails making resource commitments while the body design is still subject to frequent changes, the Japanese early design, early cut approach entails significant risks of waste and duplication of resources…. Many engineering changes occur after final release of blueprints. At peak, hundreds of changes are ordered per month.

Behind the wait to design, wait to cut approach in U.S. projects is a desire to avoid expensive die rework and scrappage, which we would expect to be an inevitable consequence of the bold overlapping that characterizes the Japanese projects. However, our study revealed a quite different reality. U.S. firms, despite their conservative approach to overlapping, were spending more on engineering changes than Japanese firms. U.S. car makers reported spending as much as 30-50 percent of original die cost on rework due to engineering changes, compared to a 10-20 percent margin allowed for engineering changes by Japanese products.

The Japanese cost advantage comes not from lower wages or lower material prices, but from fundamental differences in the attitudes of designers and tool and die makers toward changes and the way changes are implemented…. In Japan, when a die is expected to exceed its cost target, die engineers and tool makers work to find ways to compensate in other areas…. Die shops in high-performing companies develop know-how techniques for absorbing engineering changes at minimum cost…. In the United States, by contrast, engineering changes have been viewed as profit opportunities by tool makers….

Suppose a body engineer decides to change the design of a panel to strengthen body-shell rigidity. The high performers tend to move quickly. The body designer immediately instructs the die shop to stop cutting the die on the milling machine. Without paperwork or formal approval, the body designer goes directly to the die shop, discusses modifications with the die engineers, checks production feasibility, and makes the agree-upon changes on the spot. Unless the changes are major, decisions are made at the working level. Traditionally, the die shop simply resumes working on the same die. Paperwork is completed after the change has been made and submitted to supervisors for approval. The cost incurred by the change is also negotiated after the fact. The attitude is “change now, negotiate later.

In companies in which die development takes a long time and changes are expensive, the engineering change process is quite different. Consider the context in which changes occur. In extreme versions of the traditional U.S. system, tool and die makers are selected in a competitive bidding process that treats ‘outside’ tool shops as providers of a commodity service. The relationship with the die maker is managed by the purchasing department, with communication taking place through intermediaries and drawings. The individuals who design the dies and body panels never interact directly whit the people who make the dies.
You would think that tool and die makers in Japan must be a department inside the automotive company. How else could it be possible for a designer to walk into a tool and die shop, stop the milling, make changes, and start up the milling again, leaving approvals and cost negotiations for later? But this is not the case. Tool and die makers are supplier companies in Japan, just as they are in the U.S. The difference lies in the attitudes of the different countries toward supplier contracts.

For Toyota in particular, a supplier is a partner. The basis of this partnership is a target cost for each area of the car. This translates into target costs for all development activities, including dies. Of course, U.S. companies have target costs for each component also, but they tend to impose the cost on the supplier without regard to feasibility. This has a tendency to create a win-loose relationship, leaving the supplier no option but to recoup costs through the change process.

In contrast, Toyota does not impose cost targets on suppliers that it does not know how to meet, and engineers from both companies work together to meet target costs. If something goes wrong and the targets cannot be met, Toyota shares the problem in an equitable manner. In this win-win environment, arms-length exchange of information through written documentation and an extensive change approval processes is unnecessary.

The Toyota Production System is founded on the premise that superior results come from eliminating anything which does not add value. Since control systems do not add value, they must be minimized, just like inventory and set-up times. Therefore supplier partnerships based on shared risk and trust are the preferred relationship. The hallmarks of these partnerships are worker-level responsibility for meeting business goals, intense communication at the technical level, a stop-the-line and fix-it-immediately attitude, and an emphasis on speed. Even for large, one-of-a-kind development projects which require highly specialized design, this approach produces dramatically superior results.

Can this work for Software Development?
Developing specialized dies is not that much different than developing specialized software. The key is to establish a partnership relationship which allows true development to take place. Development is done using a repeated cycle of design-build-test, allowing the solution to emerge. The question is, how can a contract be written to support the emergent nature of development?

Neither fixed-price nor flexible-price contracts support the nature of software development. Development always involves tradeoffs, and an organization which facilitates the best tradeoff decisions will produce the best result. Before-the-fact contracts do not support the give-and-take between developers and customers necessary to make the best tradeoffs. A developer should not have to worry about dealing with problems as they arise, but with before-the-fact contracts, this activity has to be paid for by one company or the other. Since every hour must be accounted for, the give-and-take necessary for trade-off decisions is discouraged.

What is needed is a contract approach which allows developers and customers work closely together to develop a business value for a target cost. Examples of how to do this in a vertical organization abound. There many successful examples of using Scrum for product development. Microsoft’s approach to product development is documented by Michael Cusumano in Microsoft Secrets, Simon and Schuster, 1998. The general approach is to set a clear business goal, fix resources, prioritize features, deliver working software in short cycles, and stop working on features when time runs out. This approach has a track record of delivering systems, even large ones, in a predictable timeframe for a predicable cost.

The question is, how can a contract be written to support the same approach? The answer is to move to after-the-fact contracts in which a supplier is paid for the value of the work they do. It works like this: A customer has a clearly defined business value and a target cost in mind for achieving that value. This target cost includes payments to a supplier for their contributions. The customer comes to an agreement with a supplying partner that the business value and the target cost are achievable, including the target cost for the supplier’s participation. Work proceeds without contractual guarantees that the value will be delivered or the target cost will be achieved, but both partners are committed to meet these goals.

Workers at each company use adaptive processes[2] to develop the system as a single team. They communicate intensely at the developer-customer level to make the necessary tradeoffs to achieve the value within the target cost. As working software is delivered, both supplier and customer work together using velocity charts to monitor development progress. If adjustments to the business value or the target cost structure are required, these become apparent early, when they can be addressed by limiting the feature list or extending the schedule. If this changes the business value or target cost, the parties negotiate an equitable way to share the burden or benefit.

Trusted-based partnerships are the first requirement to make after-the-fact contracts work. Partnerships are necessary to facilitate worker-level responsibility for meeting business goals, intense communication between developers and users to make optimal tradeoffs, daily builds and automated testing to facilitate a fix-it-immediately attitude, and a focus on early delivery of working software to create the feedback system critical to good development.

Companies that develop contracts allowing these values to flourish can expect to produce the same dramatically superior results in software development that these values produce in product development.

Lessons for Outsourcers
If your company outsources software development, consider the following:

1. Fixed Price Contracts
Fixed price contracts are risky. There is both a technical risk that the job can’t be done for the allotted cost, and the very real risk that the selection process favors less knowledgeable suppliers. If you assure that you get a competent supplier, then you can be sure the supplier will add a good margin to the cost to cover their risk. Remember that risk should be born by the party most able to manage it, so if the project is complex and changes are likely, you should assume the risk. If the project is a wicked project, you should not even consider a fixed price contract.

If you are considering a fixed price contract, you are probably interested in transferring all responsibility to your supplier. But remember, if this results in a win-loose situation, you will not win. You are going to be committed to the supplier before the cracks begin to show, and if things go wrong, you will suffer as much, if not more, than your supplier. You may have to bail them out. They will no doubt be looking to make up for loses through change orders, so you will have to control these aggressively. That means if your project is prone to uncertainty or change, you really don’t want a fixed price contract.

And finally, it is much more difficult to get what you really need under a fixed price contract. If you got the low bidder, you probably did not get the supplier most familiar with your domain. If the bid was too low, your supplier will want to cut corners. This may mean less testing, fewer features, a clumsy user interface, out-of-date technology. You are going to need to carefully limit user feedback to control changes and keep the price in line, which will make it more difficult to get what your users really want.

Traditional Control Processes
Traditional project management processes tend to emphasize scope management using requirements traceability and an authorization-based change control system. Typically cost control is provided with some variation of an earned value measurement. The first thing to realize is that all of these techniques are expensive and do not add any value to the resulting software. These practices are meant to control opportunism, and if you are concerned that your supplier might take advantage of you, they might make sense. (But try partnerships first.)

You most likely do not want to be using these practices inside your own company; they get in the way of good software development. It’s pretty well known that an iterative approach to software development, with regular user communication and feedback, is far better than the waterfall approach. However, those pesky project management practices tend to favor waterfalls. It’s a good bet that your project will be subject to change (users change their preferences, technology changes, someone forgot a critical requirement), so you want to be using adaptive processes.

2. Trust-based Partnerships
For starters, all internal development should be based on trust-based partnerships – after all, that’s why you are doing inside development in the first place! If you can’t trust someone in your own company, who can you trust?

The fastest, cheapest way to develop software with a supplier is to let their technical people make decisions based on close interaction with and regular guidance from your users. You get the best results and the happiest users this way too. This kind of relationship requires risk sharing and excellent on-going communications. In exchange for this investment, trust-based partnerships adapt well to change and uncertainty and are most likely to yield faster, better, cheaper results.

Lessons for Contractors
If your company supplies software development, consider the following:

1. Fixed Price Contracts
You owe it to your customers to educate them on the pitfalls of fixed price contracts. Make sure they understand that this will make it more difficult for you to deliver the best business value.

2. Traditional Control Processes
Don’t accept traditional control mechanisms; there are better ways. Instead, use prioritized feature sets, rapid iterations and velocity charts to monitor projects.

Never allow the customer to fix cost, schedule and features simultaneously. Preferably, you want to agree to meet cost, schedule and overall business value targets, and provide a variable feature set. If the detailed feature set is not negotiable, then at least one of the other two must be flexible.

Find out what is REALLY important to your customer in terms of business value and deliver that.

3. Trust-based Partnerships
Your top priority when negotiating the relationship is to assure that your development team will have constant user involvement and feedback. You can negotiate what this means and who represents the user, but if you don’t have access to users or a user proxy, you will have a difficult time delivering business value. And delivering business value must be your main objective.

[1] A Wicked Problem is one in which each attempt at creating a solution changes the understanding of the problem. See “Wicked Projects” by Mary Poppendieck, Software Development Magazine, May, 2002, posted on this site under the title “Wicked Problems.”

[2] For a discussion of adaptive processes, see “Wicked Projects” by Mary Poppendieck, Software Development Magazine, May, 2002, posted on this site under the title “Wicked Problems.”

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