“The customer really doesn’t want a drilling machine, he wants a hole in the wall”
As government agencies and businesses across all industries come under increasing pressure to deliver more value within constrained budgets, organisations are looking to an outcome based contracting model for a solution.
Outcome based contracts, where customers pay for pre-agreed ‘outcomes’ rather than for prescribed products and services, are not new, but are gaining increasing attention. A saving of a trillion dollars in the United States over the next decade has been forecast for the successful rollout of an outcome based payment model in government healthcare spending. The World Bank, as part of a two year review of its procurement framework, has highlighted outcome based contracting as a key area of focus for enhancing procurement efficiency.
The model has been adopted as a preferred procurement strategy internationally for many years in the public sector. So what has been holding it back from more mainstream adoption, particularly in the private sector? We examine some of the key challenges that both customers and service providers face in drafting and negotiating an outcome based contract and identify ways of managing them.
What is outcome-based procurement and how is it different to more conventional contracting models?
Under an outcome based approach, a customer contracts and pays for business results delivered by a service provider, rather than for defined activities, tasks or assets. The contract focuses on the desired outcome of the work to be performed (the “what”) rather than the manner in which it is to be performed (the “how”). The service provider decides how it will deliver on the customer requirements – and thus a degree of both control and risk shift to the service provider.
Rolls Royce ‘Power by the Hour®’ is one of the oldest and best known examples of an outcome based business model. Over 20 years ago, Rolls Royce transformed its support and maintenance contracting model for engines used in commercial jets. Instead of charging customers for repairs, maintenance and the provision of spare parts, customers paid a fee per hour based on the number of hours of flying time for an engine. The company recognised that by focusing the contractual arrangement on the real underlying need of the customer – keeping a jet in the air – it could deliver greater satisfaction to the customer whilst at the same time reduce inefficiencies and increase its own revenue. This contractual structure has since become the industry standard in commercial aviation.
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There are some variations to the basic outcome based procurement model, but all outcome based contracts will typically have the following three fundamental characteristics:
- A focus on business outcomes rather than activities and tasks.
- The use of measurable performance standards that are tied to the required outcomes.
- A pricing model that comprises or includes rewards and risks.
These key elements of an outcome based contract are inter-related – outcomes need to be translated into measurable performance standards – and delivery against the performance standards is used to determine the amount of fees paid. They are also usually the same elements that present parties with the most difficulties in successfully negotiating and documenting an outcome based contract.
Users of outcome based contracting
Government agencies have been the biggest users of outcome based contracts to date. They are used in a wide range of public programs and services, including defence and aerospace contracting, health services, logistics, maintenance of transport infrastructure and welfare, employment and skills programs.
The outcome based procurement model was pioneered in the U.S. as far back as the 1960s, but use of the model worldwide is increasing. A number of government agencies now formally endorse, or even mandate, this form of contracting.
In Australia, almost every State and territory has been trialling, adopting and promoting outcome based contracting to varying degrees for a number of years. In New South Wales, the State Government explicitly endorsed the trial of outcome based procurement in its 2013/2014 roadmap for procurement reform.
That said, one size does not fit all. An outcome based approach is not always suitable and some services, industries and organisations will be inherently better placed to obtain the full advantage of this contracting model than others. For example, in some cases an organisation’s objectives may be adequately served by procuring a particular product. Hybrid contracts, where both outcomes and process specifications are set out, are often used in the public sector for large-scale projects.
Advocates of outcome based contracts point to the following benefits:
- Cost savings
- Supporting innovation on the part of the service provider
- Closer alignment of objectives between the customer and the service provider
- Increased motivation for the service provider to achieve the best outcome to maximise its financial gain
- More responsive to customer requirements
- Greater efficiency in service delivery, through allowing the service provider flexibility in its method of delivery and an ability to adapt to technological advancements
- Better outcomes for customers.
Challenges for ‘outcomes based’ contracting
Despite the many advantages seen by both customers and service providers who are parties to successful outcome based contracting arrangements, this contracting model is still not standard practice. Below are some of the key challenges that organisations face – and need to understand – in successfully implementing an outcome based strategy.
1. Defining the desired outcomes
Unlike more conventional contracting models, outcome based contracts do not set out detailed technical or operational specifications of the individual activities and tasks that a service provider is to perform, the resources used in those activities and the precise way in which the service will be delivered. It articulates requirements in the form of end goals – business outcomes – without specifying exactly how these are to be achieved.
For example, a buildings maintenance contract might specify that floors must be clean, free of scuff marks and dirt, and have a uniformly glossy finish, instead of specifying that the contractor must strip and rewax the floors weekly. Or a company looking for transport services for its personnel may require that a vehicle is ready for use, or a person is picked up, within a certain number of minutes of an agreed time, rather than the company requiring a set number of vehicles to be leased or made available.
This is a significant shift in mindset for many of those involved in the procurement process, particularly as many have an engineering or technical background, where the natural tendency can be to default to a prescriptive approach and rely on detailed process specifications in order to reduce risk.
A balance needs to be struck between defining the outcomes required in sufficient detail to ensure the customer’s requirements are understood and capable of being measured, and not unduly constraining the service provider. If the service provider’s flexibility and discretion in how those outcomes are delivered is limited, the benefit of outcome based contracting is significantly reduced. However, the autonomy given over to the service provider should not be at the cost of clearly formulated objectives – it is still crucial to ensure a high degree of specificity about the actual outcomes that will be contracted for.
Equally, the transfer of risk to the service provider must be appropriate in the context of the services in question –a service provider will resist taking on the customer’s business risks, as these will be beyond its control.
2. Measuring performance
Sound performance measures are critical to ensuring a successful outcome based procurement arrangement. At its simplest, the contracted “outcomes” should be objective, measurable, clear and realistic.
Both the level of required “outcome” and the related key metrics need to be considered and clearly set out. This is fundamental in an outcome based contract. If you can’t measure the required “outcome”, you can’t manage performance, and you can’t properly remunerate on the basis of performance. A lack of relevant metrics or unenforceable metrics is often cited as one of the primary pitfalls of implementing a successful outcome based contract.
In highway maintenance contracts, for example, where use of outcome based contracting is now prevalent (including throughout Australia), performance standards would typically include:
- specific metrics for the roughness of pavements, rutting of roads (e.g. no ruts > 15mm), surface texture and surface skid resistance, number of potholes (e.g. < 10 potholes with a diameter > 100mm on any continuous 5km stretch of road);
- specific intervals at which these features are measured (e.g. annually) or response times; and
- the specific sections of the road network to which the standards apply.
The process of establishing appropriate performance standards relies heavily on the data available. The more comprehensive, accurate and robust the data that the customer has – in particular, historical and supporting data about performance, costs, variable factors and barriers – the easier it will be for both parties to reach agreement on appropriate performance standards.
If sufficient data is unavailable, consider including a transition period to baseline the relevant standards before applying the incentives or risk and rewards payment model in full.
One of the fundamental underlying features of an outcome based procurement strategy is the direct relationship between performance and the payment of fees. Fees are not calculated on the basis of a transactional pricing model, but are tied to achievement of the agreed outcomes. This is the point at which the outcome based model has the most potential to be a ‘win-win’ scenario – the better the performance delivered to the customer, the more the service provider has to gain financially. Because the customer has not imposed prescriptive process specifications, the supplier is free to produce innovative, cost effective solutions for the benefit of both parties.
There are a number of ways in which the pricing model can be structured, each designed to drive quality performance and efficiency. Pricing options include a combination of positive and negative incentives (though the focus should be on the positive), a gainshare model, contingency arrangements and cost-plus mechanisms. Some contracts will comprise a fixed fee or lump sums, with one or more additional mechanisms under which the service provider can earn increased fees by exceeding expectations. Many will also contain a downside, where the service provider stands to lose revenue for sub-standard performance.
In each case, the emphasis is on having the right incentives in place to encourage the desired outcomes.
The Washington State Lottery, in its contract with an advertising agency, provides an example of how fees can be linked to performance. The agency originally earned 15% of the contract value for specified tasks, such as advertising services, production activities, printing and media buys. The contract structure was overhauled to be more performance based. The amount of fees paid to the agency was directly linked to the number of lottery ticket sales (i.e. linked to effective advertising, rather than to advertising activities), with a range of between 90% and 115% of the base fee.
Perhaps the biggest hurdle many organisations face in moving to an outcome based model, more than the commercial, operational and legal issues and challenges that it entails, is the cultural shift in organisational thinking. Procurement personnel need to relinquish a large degree of control and the reassurance that a prescriptive approach often brings. If a service provider is to be responsible for achieving the outcomes, it must have control over the process and the method of delivering those outcomes. Often a lack of training or excessive risk aversion of procurement personnel results in organisations defaulting to the status quo.
In the current economic climate, with organisations increasingly under pressure to extract more value from their service providers, deliver results and remain competitive through innovation, the adoption of outcome based contracting is gathering pace. As familiarity with the model grows, and the advantages that organisations stand to gain over traditional contracting models are more publicised, this trend is set to continue and all parties involved in the procurement lifecycle need to understand the issues involved.