Performance-Based Contracts | Article

Folded BillsQuestion: How do you find the right mix of freedom to get the job done for the supplier and control over the process for the customer?

Answer: Performance-based outsourcing contracts.

These contracts have emerged as the best practice structure for government outsourcing in the last three years, according to Adrian Moore, director of privatization and government reform for the Reason Public Policy Institute, a think tank in Los Angeles, California.

Performance-based contracts focus on outcomes rather than the prevailing process. It shifts the “brain work” of determining the best solution to the problem from the customer to the supplier. Now it’s the supplier’s turn to put the service package together.

The trend is to get away from the old style contract where the customer takes all the risk for cost increases or schedule creep. These contracts defined all the specifics up front. A customer who signed a typical IT outsourcing contract in the past would have been extremely specific about the hardware and software it demanded or the number of people required to man the help desk.

Unfortunately, customers tend to ask for the same old thing. Unless they keep up with the technical journals, they may not know what to specify. That’s why it makes sense to make the selection process the supplier’s job. They are constantly in the marketplace, keeping tabs on the latest developments.

The biggest change is that contracts don’t try to specify the inputs like material, personnel or practices. Instead, the contract discusses the outcomes the customers needs. In this example, they want their computers to be able to perform certain tasks, they demand a high customer satisfaction level and they need their networks available 24/7. Now, it’s up to the vendor to prescribe the software, hardware and manpower needed to do the job.

“The agency does not have to know in advance what hardware and software it will want in future years – as if it could anyway,” says Moore. Now the supplier determines the best way to meet the performance goals as the contract terms wears on.

Letting the suppliers make the final decisions has been difficult for some agencies in the government sector, says Moore. “Sometimes they think they have all the answers,” he observes.

Innovations That Make Sense

Moore likes performance-based contracts because they allow suppliers to innovate. “You want to try the best ideas possible,” he says. In addition, this type of contract allows vendors to compete on their abilities, not just on price. They can use their experience and economies of scale in their negotiations. “There’s more to discuss than ‘Can you shave your profit margin a little more?'” Moore notes.

He says performance-based contracts let the customer become an educated shopper. Now there are many choices because the customer can select the preferred solution as well as the best price.

Incentives form the backbone of performance-based contracts. The payment structure rewards the supplier depending on how well it met the performance measures stated in the contract.

Performance-based contracts force both sides to share the risk of changes in costs or schedules. But it shifts most of the risk of solving the problem to the supplier. If the customer commands the supplier to do things a certain way, the customer is assuming all the risk that this was the correct decision. The risk shifts to the supplier when a customer outsources based on outcomes. Now the supplier is responsible for the choices it makes.

Moore acknowledges performance-based contracts are “trickier to negotiate.” Because of clarity of the service level agreements, these contracts turn out to be more complex than most outsourcing agreements.

Contracts With Carrots and Sticks

Moore says government agencies like performance-based contracts because there’s “more carrot and stick involvement.” These controls make them more comfortable with privatizing. Of course, government agencies also like to do business with suppliers that they believe can deliver the solutions they promise.

Performance-based contracts are becoming more popular in the government arena, extending from the federal level to the state and local level, according to the analyst. “Government agencies like them because they work,” he says.

Lessons from the Outsourcing Primer:

  • Performance-based contracts are based on outcomes and don’t focus on the process.
  • Performance-based contracts allow both buyer and supplier to share risks but shift the risk of selecting the solution to the supplier.
  • These contracts encourage innovation.
  • These contracts are becoming the best practice contract in government outsourcing.

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