What is the purpose of a penalty clause? In short, the use of a penalty clause has a twofold function. On the one hand, it acts as a stick in terms of compliance with the contract, as an alleged incentive for performance; on the other hand, the penalty clause has a damage-fixing function.
The damage-fixing function of penalties comes into effect in the event that there are no more solutions and compliance is impossible. We won’t get into more detail about that in this blog. When applying fines as referred to here, clients primarily intend the means of control. There are also other rules and regulations governing the fixing of damages or compensation. A third function: ‘political considerations’. In other words, the client’s behaviour is covered. So that when things go wrong, one can show:
Look, I’ve taken a penalty. I’ve done everything I can to ensure proper performance.
Penalties as a stimulus for better performance
What consequences does the inclusion of penalties have for cooperation and performance? The stick to beat is nothing more than a means of control that gives the apparent certainty that the client is controlling and influencing a supplier with it. A false certainty? Sure! Best Value teaches us: ‘There is no control!’ As the picture in this blog shows: No matter how high a penalty is, what a supplier cannat do, he won’t be able to do. A penalty clause is Manage, Direct and Control, with which a client, instead of leaving it to an expert to find a solution, wants to force a supplier to deliver better performance.
Better performance under duress?
You may wonder if someone gets better under the threat of punishment. Would a supplier really run faster because there’s a sword hanging over his head? And if he needs that in order to perform, did you select the right party? In addition, by including penalty clauses, suppliers will bid on a risk basis, with a focus on price and limiting the excess rather than delivering quality and achieving objectives. In this way, you select the contractor who can does this the best instead of the party with the best plan.
Increasing the price
And let’s not fool each other: as a client, you simply pay the penalty yourself. Suppliers carry out a risk analysis beforehand and it is simply included in pricing, as a risk premium or otherwise.
No focus on performance
Furthermore, a penalty will result in the wrong focus at the moment when the focus on the proper execution of the project and achieving a good result is most needed. If a situation arises on which a penalty clause is focused (non-performance), a discussion and fight will always start when applying the penalty; accusing, evasive and negative behaviour. Yet it is precisely in this situation that you need to join forces and work on solutions.
And especially in situations where something is not going well, an unexpected event or a risk occurs, you want a supplier that acts transparently and comes up with measures to limit the impact as much as possible. When a fine is hanging over his head, a supplier will initially focus on limiting his own damage and reducing or avoiding liability. He won’t be inclined to be transparent. The inclusion of a fine does not contribute to solving the problem and achieving a good result, but rather ensures non-transparency and thus increases the risk.
Best Value without penalty clause
The use of penalty clauses and bonus-malus clauses to steer and control the supplier is counterproductive to what we aim for in the Best Value approach. Forget the false security of penalty clauses and opt for real performance. In order to actually apply the philosophy of Best Value, we have to let go of all forms of Manage, Direct and Control and go for Listen, Observe and Align (listening, measuring and tuning).
Do you want to know how you can work with suppliers who feel responsible for achieving excellent performance and who operate proactively, without the use of penalty clauses? Please contact us.