The function of service credits is to get the supplier to stay engaged and do its job properly. Suppliers can get distracted. Their attention can shift away from existing customers to, typically, new customers so service credits are an effective mechanism by which a customer gets the supplier to change their behaviour and focus. Think of them like a tax that customers charge to suppliers that neglect them.
Service credits work best when the supplier’s fees are monthly. Applying service credits once a year is not going to be an effective way to change supplier behaviour in the short term – you’re after immediate adjustments, not many months of rubbish service levels. Of course, you can change the service credit so that it results in a monthly cash payment from the supplier, but that’s a more complicated mechanism.
The corollary of this is that there is no point setting service credits at a level which pushes the supplier into loss. You need to set the service credits at a level which the supplier finds uncomfortable not bankrupting. For example, if the supplier is making a margin of 20%, service credits of 5% of fees will take away 25% of its margin, service credits of 10% take away 50% of its margin, and service credits of 20% take away 100% of its margin. No business wants to be operating with reduced margins and it definitely doesn’t want to see its margins reduce to zero.
However there are circumstances where the service gets so bad that changing the supplier’s behaviour is not the primary objective: you just want to get out of the contract.
To cater for those situations it’s a good idea (if you are the customer) to set a level of SLAs where you can terminate the contract, no questions asked, when things are irretrievable. It’s a lot simpler than relying on the usual mechanism of material breach followed by 30 days to fix the breach.