I’ve been reading The Trusted Advisor again; I love that site. It’s all about building trust. A guest author there (Ian Welsh) has written two parts thus far on rational trust using themes common to game theory. Most specifically, The Prisoner’s Dilemma which describes possible outcomes between two people who stand the most to gain by cooperation but often don’t.

In part one, Ian explains why people are only trustworthy to the extent it’s good for them rather than you. I think too often people assume the transaction will be good for both parties when it’s not (and why you get cheated). Ian says rational trust breaks down in five ways:

When it’s no longer the long term;
When someone can cash out;
When you’re not at the table, but on the table;
When the social mechanisms of reputation and deterrence break down;
When someone has a dominant strategy, something they can force on other people.

For our purposes, I think it is too often the case that it’s not in the long term interest of the other party (say a package service provider) to cooperate (at least price-wise) the way you think it is. It is fairly easy for a provider to know this too. As in, you order a bunch of product for which you have no orders. The provider knows you’re a one-time customer, you won’t be here next season (if it’s hard enough to succeed producing to order, it’s ten times worse if you stack the deck against yourself). Since you won’t be a repeat customer, there’s no incentive to work with you on minimums or pricing.

On the other hand, it must be said that many people think the other party is “cashing out”, in other words, with the potential to make so much money on the deal they have no need to worry about making future deals. Maybe this kind of thinking is more common with patent and licensing aspirants. Either way, neither are grounded. No single customer pays our bills and we’re not making as much as people think. I have an idea on ways to deal with this constraint (the point of my entry actually) but that will come further down because Ian has other good points I want to mention.

In part two, Ian discusses not being at the table (powerlessness) and the lack of deterrence and social mechanisms of reputation. I can’t speak to every industry but ours being as fragmented as it is, there is often little penalty and given providers know it. For example, if you are doing a bunch of stuff you shouldn’t be, you’re likely not integrated into the community to know a better way to run your business. If you’re not integrated, you’re not in a position to badmouth (however justifiably) whoever it was that did you dirty. However, referrals from colleagues can act as deterrence because service providers know you have the ear of however many others (and why we have the forum). It’s difficult to have anything to bargain with if you’re isolated.

Here was the idea I came up: cost plus contracts. This is common in a lot of other businesses but I haven’t heard of it in this industry. The definition of a cost plus contract varies. Some builders use it; they show customers all invoices from the various tradesmen plus materials and mark it up 15% which covers their fee for managing the project. In other industries, cost plus includes the cost of providing the service and overhead; the plus factor being the profit margin. The percentage added on the latter deals are pretty low, on the order of 5% or less.

When I first heard of these contracts I thought it could be a cruddy deal for service providers considering there was only a >5% mark up above costs but now I’m not so sure. I do a lot of work that I don’t bill for because the cost estimate ran over so much that I end up taking a loss. I know this is also true for many other providers, sometimes we’re happy to break even.

I think cost plus contracts could be both advantageous and disadvantageous. The biggest benefit for the customer is cost transparency. The big benefit for providers is any delays created by the customer are billed to the client. Currently, we usually don’t charge customers for not being able to do a given piece of the job just because a component didn’t come in even though we have losses (often opportunity cost or losing workers because we have to send them home) because of it. Other than that customers would have to pay the full costs of work stoppage, there are other disadvantages. The one that comes to mind first is having to pay for a service party’s inefficiencies since the cost of service is rolled into the contract.

Do any of you have any experience with cost plus contracts? From the customer side, what is your thinking? On one hand you have cost transparency but the trade off is having to cover the costs of work stoppage. If a component wasn’t delivered, you’d have to go up your chain to recoup those costs. I think that is fairer though; costs should be borne by those who generate them.

On the service provider side, what is your thinking about cost plus? You have the downside of cost transparency -which could end up being a good thing since customers often think you’re scalping them- but being covered for losses on a job in which the customer doesn’t have a track record, could compel you to take risks on new customers you ordinarily wouldn’t.

I’m interested in all comers. What do you think?