As the services that are being contracted increase in size and complexity organisations increasingly use performance based contracts. These contracts link part of the provider’s fee base to key performance areas and outcomes.
Commonly, the less complex the service to be delivered, the less incentive to innovate. More complex contracts closely link performance and quality of service to profit and rewards to encourage good performance. When the purchaser and provider agree to the use of performance based contracts, certain objectives must be in place for it to succeed. Table 8 provides guidance on developing performance based contracts.
Table 8—Developing performance based contracts
Objective Methodology
Alignment of purchaser/ • performance incentives that are aligned to provider priorities the corporate strategy and direction of the
organisation
• clear identification of risk
• flexibility to allow changes to incentives, key result areas, outputs and benchmarks during the term of the contract/agreement Incentives for improved • mechanisms that deliver mutual gain from
performance achievement (ie. ‘win-win’)
• incentives to achieve improved performance
• incentives that add value to the purchaser’s business and are based on performance • incentives that are easy to administer and
can be operated in a cost-effective manner Measurement methods • results that are measurable and not based that support performance on perception only (subjectivity however,
improvements plays an important part in measurement)
• established and agreed minimum performance (mediocrity should not be rewarded)
The objective of performance based contracts is to provide incentive for continuous improvement and innovation Performance incentives can be applied to the provider, the purchaser or both parties
Ideally, if the purchaser is able to establish and agree with the provider on the performance measures from the outset of the contract, the incentive scheme should then be negotiated during the tender/contract formulation period. A performance incentive scheme may apply after the first year or at the end of the original contract term in return for attaining high levels of service. A scheme may also commence in conjunction with granting an extension and/or continuance of the contract, thus providing a bonus in the form of continued service provision without the need to re-tender to obtain improved terms. Alternatively, performance based contracts can include sanctions for non- performance, such as a percentage fee for late completion or flat rate for substandard levels of performance. It is important that contract managers pursue fair application of any sanctions in accordance with the contract and, where ‘trade-offs’ are used, they be appropriate to the objectives of the contracted goods or services.
Table 9 provides examples of performance incentives and approaches to implement. Further guidance to pricing and payment structures (eg. cost plus, unit rate) can be found in Part 2.3 Pricing Structures.
It is important that contract managers pursue fair application of any sanctions in
accordance with the contract and, where trade-offs are used, they be appropriate
Table 9—Examples of performance incentives
Forms of incentive Possible approaches
Extending the contract If the original contract was for three years, an extension could be granted for an additional one, two or three years
For a project where time is Bonus payment amounts payable per critical, the provider is given day, week or month ahead of schedule financial incentive for completing (subject to quality checks of course) ahead of time (or alternatively
penalised for late completion)
Target costs established Appropriate in an alliance relationship when the scope of services is broad and requires reimbursement at cost (established using an external benchmark). If the target is
achieved, the ratio for shared savings may be on 50:50, 60:40 or an 80:20 basis
Part (usually 50%) or all of the Appropriate when management fees providers potential profit placed are applied with ‘transparent’ pricing— at risk against achievement of alternatively, 100% of the provider’s
performance potential profit may be placed at risk
with an incentive of additional potential ‘bonus’ if performance targets are reached or exceeded
A reward at the discretion of SLAs linked to the purchaser’s strategic
the purchaser plan, would be used to measure
performance, but not necessarily to the formal incentive—the bonus is then based more on total customer satisfaction
Incentives can be important but need to be well managed
Escalation and savings
In establishing a performance based contract, organisations need to consider escalation or savings provisions. Escalation addresses the need for pricing increases over the term of the contract. In single year contracts, escalation is not normally necessary. In longer-term contracts, a facility for escalation is needed and a method of dealing with it adequately should be considered. Lengthy calculations or complicated formulas are not generally checked effectively, as time or other constraints and day-to-day pressures often apply.
As can be seen in Table 10, a traditional contract (ie. with a control and compliance focus) would generally be more suited to a 3 year contract using, say, the consumer price index (CPI) as the adjustment, as prices should be reasonably fixed and easily identifiable and caters for the changing market. Alternatively, the more flexible (cooperative, partnering and alliance)
relationships are more suited to a longer term contract using actual costs as the basis of payment as the terms of such contracts are more likely to vary.
Table 10—Escalation provisions and relationship type
Contract Type 1 Year 3 Years 5 Years Plus
Traditional fixed—no escalation CPI adjustment
Cooperative fixed—no escalation cost cost
Partnering cost cost
Alliances cost cost
Along with escalation, it is normal for the contract to provide for consideration of savings resulting from increased experience. Experience in the delivery of services may result in savings, eg. through reduced man-hours. It is common in cases where it is evident that efficiencies will be gained with experience to ask providers to state their savings per annum throughout the term of the contract, so that savings may be generated every year. Internal processes need to be in place to track and account for these.
The vertical axis in Figure 8 is typical of some private sector contracts where the providers nominate the increase in performance per year required for each year of the contract. This often results in a lower final year cost than starting year cost, even accounting for inflationary aspects of the general economy. The
It is normal for the contract to provide for consideration of savings resulting from increased experience
Figure 8—Escalation or savings