If you are producing or working with a Performance Based Contract (PBC), it means you want to reflect a fair and balanced perspective that benefits the performance of both the buyers and sellers. But a deeper look behind PBC development shows the process can get a bit complicated especially if parties disagree on what performance or fair and balanced behavior looks like.
What follows describes what you can do to avoid the obstacles to effective and accurate PBC contract management and get the results all parties are seeking.
By definition, Performance Based Contracting is an outcomes-oriented contracting method that ties a range of monetary and non-monetary consequences to the contractor based on measurable and achievable performance requirements. A PBC surrounds a behavioral “nudge” approach where the buyer tries to nudge the seller’s behavior by applying a range of complementary rewards and sanctions to deliver the seller’s outcome.
PBCs can shape the behavior of both buyer and seller. Although many commercial practitioners see contracts in their simplest form – as an explicit and direct agreement between buyer and seller -- some claim that contracts can be used for much more. At their best, contracts can define, shape and nudge positive outcomes, including behaviors in both buyer and seller.
In 2008 Richard Thaler and Cass Sunstein published the book titled Nudge: Improving Decisions about Health, Wealth, and Happiness.1 Central to the concept of nudging was the role of a choice architect who helped organize the context in which people make decisions. These choice architects help by highlighting the choices available and their relative merit while still allowing people to choose their own path.
Despite the success of the book1, some people disagree with the approach, believing that providing a nudge towards a particular choice is itself a form of bias. Even more extreme commentary claimed the “nudge” removes choice from the individual.
So, since that time, many new “nudge” approach appeared in several countries including the creation of Behavioural Insight Teams (BIT)2 that helped various local, state and federal governments design, modify and apply policies. However, applications are typically not focused on activities involving commercial contracts.
And my point is?
In the early 2000s many organizations -- especially in the Australian Defence sector -- began using the PBC format to improve performance at a lower price. Indeed, the ability for a PBC to simultaneously deliver these outcomes3,4,5,6 has made their popularity and use more widespread.
Many people designing and applying PBCs over the past decade will see similarities between the concept of nudge approach and the intent of a PBC. In other words, a highly successful PBC will do three things:
- motivate the right behavior in the seller by addressing the seller needs;
- provide adequate commercial protections for the buyer by addressing the buyer needs; and
- balance both seller and buyer needs within a usable commercial
Figure 1 shows how an ideal PBC aligns the Seller Need with the delivery of the Buyer Need described by the Commercial Construct which involves such things as:
- contract duration and extension;
- at risk amount;
- performance measures and weightings;
- liquated damages;
- stop payment; and
- termination .
Figure 1 illustrates the interaction between three areas: Buyer Need, Seller Need and Commercial Construct. To achieve all three, each PBC requires a Performance Management Framework (PMF) which “ensures that the delivery of the enterprise outcome by creating a self-regulating agreement which uses a range of incentives to guide and disable choice.”7
Figure 1 is based on an asset management scope of work where:
- Buyer Need represents the traditional specification of requirements. In sustaining complex materiel,8 these requirements can be grouped into three broad areas: asset usage, asset optimization and asset preservation underpinned by safety culture, cost consciousness and positive behaviors. Seller Need represents both the financial and non-financial outcomes required by the seller ranging from contract price and profit margin to contract duration and recognition schemes.
- Commercial construct represents an agreement (typically a contract) between the parties that is fair and motivates and delivers both buyer need and seller need. The optimal commercial construct is a balance of conventional (written) contracting protections and a collaborative (relational) contracting approach.
This concept goes beyond the Key Performance Indicators (KPI), because it shows how all facets of the contract fit together to drive behavior. Indeed, the key to successfully carrying out the PBC is self-regulation where the seller’s performance determines the commercial consequences whether they are positive or negative. This idea of self-regulation aligns with the behavioral economics idea of “nudging” where, rather than the buyer directing the seller exactly how to deliver the outcome, the performance management framework (PMF) should “nudge” the seller’s decisions by allowing the seller to make choices in full knowledge of the buyer’s requirements and consequences of the seller’s actions.
Designing a Performance Based Contract
Successful contracts deliver the desired outcomes of both buyers and sellers; the classic “win-win” outcome that we all strive for. Highly successful PBCs achieve this by balancing the requirements of both buyer and seller with the consequences (rewards and remedies) that provide both positive (carrot) and negative (stick) incentives.
If you examine the relationship among the three areas in Figure 1, you can observe the following characteristics:
- the left-hand area represents a conventional commercial construct transferring risk from buyer to seller through a prescriptive contract whereas the right-hand area is a highly collaborative (relational) approach that shares commercial risk between the parties with limited formal detail; and
- the top area meets the buyer need (asset usage, optimization, preservation, and behaviors) but it might be seen by the seller as punitive, “unfair” and a “bad deal” whereas the bottom area meets the seller need (reputation, recognition schemes, contract term, payment frequency, contract margin and contract price) . But this may be seen by the buyer as risk free providing no assurance of performance (“money for nothing”).
This relationship is illustrated in Figure 2.
The ideal PBC is balances each of these three areas represented by the overlapping region in the center of the diagram where the Buyer need is delivered by linking it to the Seller need through a fair collaborative Commercial Construct.
Figure 2 : Relationship between seller need, buyer need and commercial construct
How do we achieve this balance?
Those familiar with Thaler and Sunstein’s concept1 of nudging may disagree with my analogy of PBCs because they typically refer to nudging in a social engineering context (e.g. influencing the uptake of health insurance) and typically applied with a lighter touch. However, I believe the intent is same. Using a range of complementary rewards and remedies within a PBC creates a choice architecture that guides and disables seller choice rather than directs legal consequences of a conventional contract such as contractual breach.
I believe those of us involved in developing PBCs should consider ourselves choice architects. As such we should strive to deliver a performance management framework (PMF) that allows sellers to regulate their own behavior by defining the consequences of their actions or omissions, including positive rewards (incentives), for delivering required outcomes. One way to achieve this is to design a range of consequences that escalate based on significance of:
- how much performance varies from our requirements relating to duration;
- how the variation impacts the buyer and whether this represents a continuing or repeating performance issue.
Table 1 demonstrates this carrot and stick approach 1.
Positive Incentive (Carrot)
· Contract Duration and Extension
· Recognition schemes
Negative Incentive (Stick)
· Stop Payment
· At-Risk Amount
· Liquidated Damages
Table 1 : Incentives and Commitments9
Here we see how commitments represent consequences that are either too good to refuse or too bad to accept. In these cases, the consequences, either positive (carrot) or negative (stick), must be of such significance to disable future choice.
On the other hand, incentives represent consequences that guide rather than disable choice. The difference between commitment and incentive is simply deciding whether the consequence disables or merely guides the choice.
If you want to minimize the performance variation one approach used with good results is to simplify contract drafting. To do this you can codify a default commercial construct that includes a range of consequences that escalate based on significance of performance variation from the buyer’s requirements. The Australian Standard for Defence Contracting (ASDEFCON) suite of contract templates10 are one example of this approach.
In summary, when developing your contracts remember to make sure your “choice architecture” delivers a fair and balanced commercial construct that delivers both the buyer’s and seller’s needs. If you can do this, you should get positive outcomes and supportive behaviors. And who wouldn’t want this!
Dr. Jacopino presented a webinar to IACCM members titled Ask The Expert (APAC): An Introduction to Performance Based Contracting (PBC). Participants found this very helpful!
- Nudge (book) Wikipedia explanation
- Behavioural Insights Team (in partnership with the UK Cabinet Office)
- BOYCE, J. and BANGHART, A., “Performance Based Logistics and Project Proof Point - A Study of PBL Effectiveness”, Defense AT&L: Product Support Issue, March-April 2012
- GUAJARDO, J.A.; COHEN, M.A.; NETESSINE, S and KIM S-H “Impact of Performance-Based Contracting on Product Reliability: An Empirical Analysis”, July 2009, revised February 2010, INSEAD Working Paper No. 2011/49/TOM
- “Performance & Outcome Based Contracts 2015”, International Association of Contract and Commercial Management (IACCM), 2015
- DOOGAN, C., LINGER, H., HOLMES, D. and BJERKNES, G., “Enquiry into Performance Based Contracting Practice – Phase 2 Case Studies”, June 2018
- Blog article by author on performance based contracting
- Complex materiel can be defined as those assets that support military operations through flying (e.g. aircraft and helicopters), sailing (e.g. ships, boats and submarines), driving (e.g. wheeled and tracked vehicles) and transmitting (e.g. satellite ground stations).
- Adapted from AYRES, I, “Carrots and Sticks,” Bantam 2010
- See Australian Government Department of Defence Capability, Acquisition, Capability and Sustainment Group
ABOUT THE AUTHOR
Dr. Jacopino, best known for his work on Performance Based Contracts (PBC) and Performance Based Logistics (PBL) arrangements, has a unique and diverse set of skills and experiences based on over 30 years of commercial, engineering and logistics experience for both the 'buy' and 'sell' side of contracts in the Defence environment firstly as a military engineering officer with the Royal Australian Air Force, then a Defence industry contractor with QinetiQ Australia and most recently as an Assistant Secretary in the Department of Defence.
ABOUT NGAMURU ADVISORY, CANBERRA, AUSTRALIA
Ngamuru Advisory, based in Canberra but operating throughout Australia, provides strategic and commercial advice primarily to government by a staff who are passionate about delivering government projects better to benefit the taxpayer. Their mission is to provide strategic advisory and commercial services to the Commonwealth and State/Territory Governments and their related agencies.