Specify KPIs in Written Agreements

It is hard to dispute the advantages of using KPIs with supply chain providers. Equally important is making sure that these KPIs are in the contract. If a provider fails to meet its customer's required expectations, having a contract that specifies KPIs will make it easier for that customer to establish negligence or breach of contract. Without KPIs, customers are forced to rely solely upon applicable legal "standards of care."

Legal standards of care are general in nature and are applied by the court when determining whether the actions and/or inactions of a service provider led to damage arising from negligence or breach of contract. For example, in cases involving the transportation of shipments, these legal standards are used to determine who is liable for loss or damage to goods as well as damages resulting from delayed delivery. Numerous decisions in judicial systems all over the world have helped to clarify standards of care for traditional transportation services.

Nevertheless, there are a couple of reasons why parties should not rely solely on legal standards of care. First, these standards lack specificity. For example, most people in the United States are familiar with the "reasonable person standard." Many courts have interpreted this standard of care to mean "the degree of care that a reasonable person would undertake under similar circumstances." While it may seem straightforward, the "reasonable person standard" can easily become subject to opposing arguments when it is applied to any given set of facts.

Take, by way of example, the service provider that agrees to operate a central distribution center and manage an inbound logistics network consisting of more than 800 vendors, motor carriers, and equipment suppliers supporting the customer's newest line of manufactured products. During the course of transitioning the services to the new provider, numerous unforeseen problems arise. The service provider promptly gives its customer notice that these problems will result in fluctuations in the delivery times of the raw materials to the plant but that it is working with the vendors to alleviate the problems. Despite these efforts, the production lines are slowed, and the customer's monthly output goals are not achieved. Of course, both parties will retain logistics and service experts, who will analyze all the facts and testify on their conclusions. But, what would a reasonable person do in the same position as the service provider? Unfortunately, when a group of people is put into a room to decide this, the result is not always predictable.

Second, a court, jury, or arbitrator often modifies prior interpretations of standards of care retroactively when applying them to a new set of facts. In other words, unless there is a precedent opinion in the same jurisdiction where the exact same standard of care was applied to the exact same set of facts, the result is uncertain. Therefore, there is no assurance that either negligence or breach will be found to have occurred when such legal standards are applied to modern types of service-related problems as there may not be any court cases determining the correct action to take.

To avoid a broad—and less predictable—interpretation of a legal standard of care, the contract should clearly state the parties' intent for the service provider's level of performance. To accomplish this, the contract should first contain references to any statutory or customary standard of care.¹ In the United States, for example, the contract might refer to the Carmack Amendment (a federal law covering loss or damage to cargo for most inland, interstate shipments) or Section 7-204 of the Uniform Commercial Code (which most states have codified into law and covers warehousing services). The contract can then be improved by adding contractual standards, which set out measurable levels of performance in the form of one or more KPIs. These KPIs must be specific to the services being provided and contain clear minimum levels of performance.² Including KPIs not only adds specificity to the generalized standards of care but also fills in any gaps for those services that may be included as part of the agreement but are not subject to any law regarding a specific legal standard.³

Although it may seem easier to avoid standards of care altogether, please note that service standards or KPIs should neither replace nor modify applicable legal standards of care without the involvement of lawyers and, if applicable, insurance professionals. In fact, strict care should be taken in the drafting of contracts to ensure that legal standards of care are not modified or superseded by KPIs so that both legal precedent and purchased insurance policies are available in instances of loss or damage. Unless the parties are well informed of the legal ramifications, KPIs and other service standards only serve to help define such standards of care by supplementing what may be applicable by statute or case law.⁴

Examples of KPIs

There is not a fixed number or set of KPIs that should be used in every services contract. Instead KPIs are often adapted to a given industry and tailored to meet a specific customer requirement. In addition, the field of logistics is constantly changing and, thus, new KPIs are created every time a third- or fourth-party logistics provider (3PL or 4PL) supplements its existing set of products and services. That said, however, there are a number of commonly used KPIs in the transportation industry. Reviewing these KPIs may help managers understand how to develop their own KPIs for their logistics business.

On-time delivery (OTD). Customers of all modes of transportation often implement KPIs relating to the timely delivery of goods. Making delivery deadlines is crucial not only for meeting customers' purchase order or replenishment expectations but also for keeping the cost of inventory low.

Timeliness of notices. Another common KPI is timely notice of pickup or delivery. Shippers seek to include OTD and notice KPIs in service providers' contracts because shippers may be issuing invoices for the sale of goods based on the timeliness of their carriers' actions. The carriers' notices verify that such actions have been completed. This is a good example of KPIs being more useful than generalized standards of care, which, by their nature, do not refer to such specific actions or performance levels.

Accuracy and quality requirements. KPIs that relate to other aspects of the supply chain are also needed. For example, both order-fulfillment and loading accuracy are important because mistakes in these two areas can easily affect the cost of shipping merchandise from a warehouse. If value-added services are involved, then there can be KPIs concerning the quality of the finished product as well as the usage and waste of raw materials. KPIs for the care given to packaging are also essential as packaging can affect the frequency of returns.

Regardless of the KPI implemented, its primary goal must be to further develop and support the business interests of the customer. If the customer's most important business goal is to lower costs, for example, then the parties should consider a series of KPIs that affect cost savings. If KPIs are not related to achieving a real business goal, they are likely to lead to unproductive friction between a customer and its service provider. In other words, if a customer imposes a KPI without explaining its purpose and importance (monetary or otherwise), then the service provider may not take it seriously. Instead the provider may consider the KPI as merely a "hammer" that the customer can occasionally use on it. To avoid this situation, initial discussions between the parties should include how different levels of performance will affect the customer's business (both positively and negatively).

The Fundamental Characteristics of KPIs

How then should the parties determine what will make an effective KPI? Every KPI drafted in the contract should have two fundamental characteristics. First, the KPI must be written so that the service provider's degree of adherence to it can be determined objectively. This requires that the KPI be "calculable." It should not be possible to review performance with bias, unpredictable variables, or other subjective influences.

To understand better, let's revisit the example of on-time delivery and relate it to the transportation of shipments by an ocean carrier. The KPI for OTD is usually measured either from the time that possession of goods is taken by the carrier or from the time that notice is given that the goods can be collected by the carrier. Thus, the calculation begins with a trigger, which is a moment in time for starting the time period. The trigger is followed by a designated time period and, at the end, there is be a final event—usually the unloading at the port of entry—that stops the time period. The result is a measurable time period that can be calculated for each shipment. Finally, all measurements must be recorded in some manner so that the parties will have the ability to determine adherence to the KPI. In short, the first element of KPIs is an objective way of calculating performance by using triggers, measurable time periods, and records (TMRs).

The second fundamental characteristic of KPIs is that they have a minimum performance requirement. This is sometimes called a "target" or "goal." But while a "target" or "goal" implies that any performance close to the target or goal is acceptable, a KPI should clearly state what is unacceptable by establishing a minimum level of performance.

The establishment of a minimum performance requirement does not mean that customers should expect perfection. The effectiveness of any KPI is dependent upon its reasonableness. The parties should understand that it is not possible to perform with 100-percent accuracy all of the time. Recognizing this, the KPI language or stated goals in the contract may provide for a degree of flexibility. For example, the KPI may indicate an acceptable performance range lower than the stated "goal." Consequently, if the provider performs within that range, it will not result in a termination of the contract. Instead, the customer may issue a penalty or a probationary period, which may ultimately lead to termination if certain performance conditions are not met. This is a good compromise as inflexible KPIs can lead to "finger-pointing" by all parties involved. These situations can deteriorate rapidly since the parties are likely to take defensive postures, instead of working together to ameliorate the conditions. Thus, it is important to conduct frequent meetings to discuss performance, flexibility, and cooperation (and parties often include language in their contracts to require such meetings).

A final consideration before deciding whether to include a KPI in the contract is the financial investment that KPIs invariably require. Because each KPI must be recordable, a process for measuring, monitoring, and reporting performance must be developed for each KPI. This can result in costs ranging from hiring additional people to customizing a new warehouse management system. In short, the more sophisticated the KPI, the larger the budget needed to implement it.

Furthermore, companies must take certain steps to make sure that these reports cannot be based on false or incorrect information. Both parties must ensure that KPIs are not implemented before the method of measuring and reporting has some proven track record for accuracy. They should also make sure that competent data-security personnel review the method for receiving and accessing the data used to populate the reports.

Writing the Contract

When it comes to writing the KPIs into the contract, "reasonableness" and "flexibility" should again be key considerations. For many reasons, implementing every known KPI and mandating their strictest compliance is not a recommended method for improving or standardizing performance. There are better ways to achieve the desired result, depending on the complexity—or sometimes, uncertainty—of the business. Instead, the body of the agreement should contain a general provision referring to the KPIs, their purpose, and their enforceability. The provision does not have to be elaborate or complicated.

The first sentence of the provision should simply adopt any applicable legal standards of care to the services being performed and then separate the contractual obligations of the KPIs. Alternatively, if the purpose of the KPIs is to exceed the levels of performance required by such standards of care, the first sentence can be something as basic as the following:

Key Performance Indicators. The parties agree that the performance standards specified on Schedule "A" (KPIs) shall be minimum requirements for the Provider⁵ fulfilling its service obligations under this agreement directly related to such KPIs, notwithstanding any standards of care applicable to such services under either (i) existing law, statute, or regulation or (ii) other provisions of this agreement.

It should be noted that the foregoing specifies only "service obligations...directly related to" the KPIs that are listed. It is not intended to exclude the application of legal standards of care to, for example, lost or damaged goods. If, however, the contract includes KPIs for loss or damage to goods (or even equipment owned by the customer) that may be different from the level of performance required by the standards of care, then the beginning of the provision should be slightly different. It should eliminate any argument by the customer that an applicable legal standard of care will be enforceable, even if the service provider meets the requirements of the relevant KPIs.

The next sentence of the contractual provision should address the mechanics of how each KPI will be measured and reported. Again, it does not have to be complicated, but it should specify the periods of time for measuring performance and establish deadlines for determining and reporting the performance.

Within [5/10/15] days after each [week/month/quarter] (Reporting Period), the Provider shall deliver to the Customer a report itemizing each KPI and the actual performance achieved for every KPI during the immediately prior Reporting Period.

The parties can also add a short optional sentence if (a) they agree to allow some flexibility in the actual performance or (b) the methods of measuring or reporting the performance cannot provide the detail required for specific data results.

Performance shall be averaged on a [daily/weekly/monthly] basis.

The rest of the provision deals with how to handle any future changes to the assumed business model. This section is important because the service provider agrees to meet the requirements of all KPIs based upon its analysis of historical and other pertinent information provided to it (usually from its customer). If conditions change, the provider's ability to meet the KPIs may also change. If, for example, consolidation services are being provided to optimize the stuffing of goods in 40-foot containers and products arrive from vendors that are too tall, too wide, or too heavy to meet the utilization requirements for the containers, how will this affect the ability of the provider to meets its KPI requirements? Thus, the following should be inserted to ensure that the KPIs are not set in stone if conditions change that are outside the control of the service provider.

Each KPI is subject to the assumptions specified in Schedule "A" and, in the event that any assumption changes during the Reporting Period in excess of [10/15/20] %, averaged on a [daily/weekly/monthly/quarterly] basis, then any KPIs affected by such assumption are suspended for such Reporting Period; however, the Provider has an ongoing obligation to exercise diligent efforts to perform in accordance with this agreement. As soon as practical after such an event, if any, the parties will re-negotiate either the KPIs or the rates to ensure that compliance is reasonably possible in the future if such changes recur. Immediately thereafter, Schedule "A" shall be amended accordingly to govern any new term or condition agreed upon.

Once the above language is inserted in the body of the contract, then the KPIs themselves should be listed and defined in an appendix, schedule, or exhibit to the agreement. (This is the Schedule "A" mentioned in the above examples.) Likewise, each assumption for each KPI should be similarly listed on the same attachment. This allows for some flexibility if the relationship, the services, or even the business priorities change.⁶ By putting KPIs on a separate and removable page, it is simple to modify or supplement the contract. This format is an especially good fit for those agreements that are customized and negotiated provision by provision. It provides an easy and constructive way to modify KPIs and their assumptions without creating an opportunity to reopen other issues in the contract.

The KPI attachment can be created easily by using a table or chart. The benefit of this approach is twofold. First, this format will ensure that each KPI is legally separated since each will be reported and enforced separately. Second, the process of creating the table or chart should result in a clear articulation of each trigger, method of measurement, and minimum requirement. From an operator's perspective, it is much easier to focus on a table or chart than an entire contract. In fact, it is not unusual for the parties to develop reporting matrices that track identically to the table or chart in the contract since it makes compliance easier to interpret. Thus, a table or chart is an easy method to establish the minimum service requirement (usually in the form of a percentage for types of services that involve multiple or repetitive activities). A very basic sample of a table containing four KPIs is given in Exhibit 1. Keep in mind that KPIs are to be measured retroactively over a defined performance period.

To provide additional flexibility to the KPIs in Exhibit 1, a matrix of similar KPIs can be created with targeted goals; the actual requirement would be for the overall average to exceed a stated percentage. For greater complexity, the stated goals can also be given weighted averages depending on (1) their respective importance to the customer's business, and (2) the difficulty that the service provider may have adhering to such levels due to external constraints.

It should be underscored that the existence of KPIs in the agreement makes them a legal obligation of the service provider. However, there are other ways to use KPIs without implementing them as merely minimum requirements, failure of which could result in termination of the contract. Another popular method of using KPIs is as part of an incentive program for superior performance—sometimes called gain sharing. This allows both parties to benefit from superior performance.

A few final issues bear mentioning. First, it is common to have lower KPIs during the startup period of a new relationship. This allows both parties time to get comfortable with the accuracy of the information being generated, the information received, the operational procedures, and the management of the activities being performed. While this step may not be necessary for traditional transportation relationships, it is a good idea for complex activities. Consider the example of a service provider taking over the management of an inbound logistics network. If the old network included multiple storage locations, each with a different series of freight management delivery and pickup protocols, it is common to have a period of overlap during the transition of the services. In such cases, the new provider will not yet be familiar with the "normal" flow of goods. The ramp-up period should lessen the impact that such rapid changes in volume, vendor management, and distribution will have on the new provider. It will also avoid conflicts that could arise from trying to determine who is responsible for lost or damaged product still in active inventory managed by the former service provider.

Similarly, some flexibility should be given if the customer requires an increase in the KPIs' goals over the life of the contract (for example, a 10-percent increase every year) or some other form of continual improvement. Both parties should consider what the amount and extent of improvements should be, how to verify any new information, and whether the service provider will be able to commit to such increase automatically.⁷

Finally, it should be pointed out that KPIs are not always a one-way street. Often, the service provider is reliant on the cooperation of its customer. It is not uncommon for each KPI to be subject to certain actions or deliverables on the part of the customer. The customer's obligations—like those of the service provider—should be included in the contract as well. The important thing to remember is that KPIs can be designed to include both parties' obligations while setting achievable standards. (A list summarizing other tips is included in the sidebar on page 26.)

In conclusion, the advantages of using KPIs should outweigh the disadvantages in almost all situations. Service contracts with minimum standards tailored to the business will result not just in more consistent performance but also in more predictable levels of service. They also make it far easier for a judge, arbitrator, or jury to determine whether a failure constitutes a breach of contract by the service provider. The ultimate rewards to both parties are that the inclusion of KPIs adds certainty to the contractual relationship, better enabling its parties to assess their respective roles, perform their obligations well, and price their businesses accordingly.

Author's Note: This article should not be construed as legal advice or a substitute for obtaining the advice of legal counsel in relation to any given matrix of facts and applicable law.