15 Incentive Contracts Advantages and Disadvantages

An incentive contract is a sub-segment of a fixed-price or cost-reimbursement contract when there are specific cost or time commitments that are desired for a project. The standard incentive contract will allow for a fixed price to be paid for work to be completed by a specific deadline and at a specific cost. If the contractor is able to complete the project sooner, cheaper, or both, then an incentive is paid for that accomplishment.

Some incentive contracts may offer a sliding scale of guaranteed incentives based on the amount of time saved or costs that are reduced. These contracts can also be designed to provide a specific benefit if certain stipulations within the contract are met as described.

There are several advantages and disadvantages to consider when looking at the overall structure of the modern incentive contract.

List of the Advantages of Incentive Contracts

1. It creates more ownership over the work being completed.

When there is an incentive to earn more for work that meets specific stipulations, there is greater ownership by the contractor over the end result. They get to be in control of the final outcome, deciding if the incentive is worth the effort to meet specific deadlines. That allows most incentive contracts to build higher levels of commitment to a high-quality outcome compared to other types of contracts which may be offered.

2. It incentivizes innovation.

Incentives encourage contractors to be innovative in their approach to projects at an individual level. Instead of producing the same type of result in project after project, incentives encourage creativity in the approach by awarding those who are able to exceed expectations. Every project must meet certain building codes and expectations. Basic contracts can make this happen. If you want your contractor to do more or use their experience to your advantage, paying through incentives can make that happen.

3. It promotes better lines of communication during the project.

When incentives are in play, contractors and ownership tend to communicate more often with one another. Both parties have advantages here. Owners receive frequent updates about their project, which creates more overall accountability for the work being completed. Contractors receive more feedback over the work being completed, which allows them to pursue the maximum incentives provided by the project. Over time, this tends to lead toward closer levels of cooperation as well when communication lines remain open.

4. It encourages skill-based personnel assignments.

When time or quality are not part of the contract negotiation process, it is more likely that inexperienced workers will be assigned to specific tasks for the project. When you are able to incentivize key components of a project, there is an incentive for contractors to put their best people into the required skill-based assignments. If there isn’t enough skill or experience available internally, incentive contracts encourage contractors to hire new employees which have what is required to complete the project on time.

5. It allows for better management oversight on projects.

Many contracts are straight-forward propositions. Do a specific job, then receive a specific payment in return. Because incentives require verification to be paid, there is a necessary excuse for management or ownership to have more oversight over an entire project. This creates more accountability within the relationship for both parties, providing mutually beneficial guarantees. Contractors know that there is a better chance that their incentives will be paid. Managers know that there is a better chance that the work will be completed to the quality levels required.

6. It promotes higher levels of personal discipline.

Incentive contracts also promote an approach which tends to be more disciplined. Contractors use the information available to them to work toward the incentives they want. Owners use the control systems in place to manage the relationship in such a way that contractors feel supported instead of micromanaged throughout the process. That higher level of discipline will typically generate better results for everyone involved.

7. It allows for positive or negative incentives to be included.

When negotiating an incentive contract, the focus is often placed on the positive incentives which are offered to the contractor. Owners or managers have the opportunity to have positive incentives included for them as well to protect themselves against negative outcomes created by the contractor. Penalties, remedies, and rewards can all be mixed together, for both parties, to ensure that a fair and equitable contract is created for a project.

8. It allows for non-monetary rewards to be offered as an incentive.

Although cash is usually a top priority when negotiating an incentive contract, there are non-monetary items that can be given out as rewards for a job well done too. One of the most unique options in this category is the award of a U.S. savings bond. These items are classified as a non-monetary item because it is a federal contract that is being purchased. It still symbolizes monetary value, offers lasting value with its holding period, and can be used within the public sector.

List of the Disadvantages of Incentive Contracts

1. It creates additional administrative costs for ownership.

Because there are more oversight responsibilities involved with an incentive-based contract, there are higher administrative costs that must be assumed by owners or managers. Some contractors may also experience higher admin costs as they track the data necessary to apply for the incentives built into their contracts. Other contract forms tend to be simple and straight-forward, requiring minimal oversight because there are automatic quality guarantees built into the agreement.

2. It requires extra negotiation time.

Because the incentives are an extra part of the contract, owners and contractors must engage in an extra set of negotiations to hash out what the final incentives will be. There are numerous types of incentive contracts which may be offered, from automatic incentive formula to sliding scale percentages to fixed-rate bonuses. Each incentive included in the contract requires a point of negotiation, which ultimately delays the start of the project for everyone.

3. It can change the priority of the contract.

If incentives are included within a contract, then it may change the priority of the project being contracted out. Instead of focusing on the main elements of the project and the costs involved, the attention is put on the bonuses that are offered when specific conditions are met. If a renegotiation is required, then the incentives included would need to be re-examined as well, which adds further delays to the project.

4. It increases the risk that a dispute will occur.

If you have a basic contract that governs work being completed, then you have one basic area where a dispute may occur. For that reason, the terms and conditions of the contract must be outlined completely, to the mutual satisfaction of both parties, to ensure a quality delivery. When incentives are involved, each unique incentive becomes a potential sticking point at the time of delivery. If the contractor believes the stipulations for the incentive have been met, but the ownership does not, the dispute can quickly escalate into litigation.

5. It can be difficult to determine what a fair incentive target happens to be.

If managers or an ownership group is unfamiliar with the work that needs to be done, then a contractor can take advantage of that lack of experience to setup very profitable incentives. That would drive the cost of the project upward exponentially. The opposite is also true. If an inexperienced contractor comes into a project and under-estimates what will need to be done, then an experienced ownership group can utilize unfair incentives to limit their costs. There must be a balance between the two parties in this area to develop results that benefit both sides instead of just one.

6. It does not provide a one-size-fits-all solution.

Every project is unique. That means every incentive option must also be unique. There are no incentive contracts which will universally apply. Even if the same managers and contractors are involved in multiple project, each project must have its own set of incentives negotiated for it. That’s because an effective incentive contract will reflect the values of both parties while promoting a beneficial path toward the work which must be completed.

7. It may not always be needed.

Incentive contracts are best used when there are specific behaviors or outcomes which owners or managers wish to promote. If these elements are not present within a project, then the costs of the incentives may exceed the value that they actually offer to the project.

The advantages and disadvantages of incentive contracts are useful to consider when time or quality are important elements of a project. You’re able to create more potential with incentives without compromising the baseline outcome required. When both parties negotiate in good faith, everyone can benefit from this contract structure at the end of the day. If that doesn’t happen, then a project outcome may become questionable.