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It’s de rigueur to run performance-based contracts. Deliver the agreed performance, get paid. Don’t meet the performance standard, get paid less. Should make sense, but does it?

Do the job, get paid

In a business-to-business (B2B) relationship, if a company delivers faster, better, more functionality, it’s common to share the benefits either directly or with the offer of more work. If they fail to perform, if a business costs another business money, there tends to be immediate and long-term consequences.

In business-to-government (B2G), the incentive is the payment. It is a strong purchaser-provider model. Despite the rhetoric around partnerships, B2G relationships are usually transactional. Rarely is there a true partnership with joint investment, shared risks and benefits. I’ve only seen it once in my career. Neither are right or wrong. They arise because of the different environments and it’s important to recognise that they are quite different.

No matter how many times government buyers seek vendors to make choices in the best interests of the public or government, it doesn’t happen. The vendor’s overarching and indisputable obligation is to the company, the owners and shareholders.

To think they will behave otherwise is delusional. Self-interest dominates industry, though I will allow that occasionally companies act with enlightened self-interest – where the company acts in the client’s best interest above their own because they recognise that ultimately the company will benefit. That’s a difficult path when the relationship is transactional.  

B2G margins are low, stable for long periods and the pace of change and overall expectations are lower than in B2B contracts. Just doing what you say you will do, never making a wave and being easy to manage are high value propositions even if they are not an overt tender evaluation criterion.

When dealing with public procurement, every tender stands on its own merit. History matters little and no added upside for delivering more than the minimum acceptable outcome.  

KPIs linked to payment are commonly used to encourage performance to at least the level of the contracted obligations.

How do they work? Do they work?

A typical approach is to pick half a dozen KPIs that reflect the major outcomes or deliverables of the contract.  Divide the contract profit across the KPIs, with the margin only earned if all KPIs are fully met. Institute some sliding scale that reduces the margin in proportion to any underperformance.

Its sounds very professional, scientific, and logical, except …

Most vendors will simply not accept their full margin at risk.  From their perspective you, the client, will have received value and you are obligated to pay at least in part. Profit is part of the price you pay in acquiring a service.

It is often a tedious negotiation point but any reasonably competent vendor will ensure that reasonable performance on their part will return an acceptable commercial margin and not be subject to the performance regime. This makes the contract profitable and effectively turns the intended negative elements of the performance regime into an incentive payment.  

Typically, multiple unlinked KPIs act independently.  The more KPIs involved the less the collective impact on margin, making the effect even weaker. Then divided by multiple reporting periods, in the context of a contract already having an acceptable margin, the KPI based framework has little influence.

The reality is that most performance regimes in B2G purchaser-provider, transactional contracts are simply too small to significantly influence commercial behaviour. They need something that makes the company’s management, and Board, sit up and pay attention.

The ultimate sanction – termination

The ultimate sanction is contract termination. A rare occurrence requiring “material” breach, as it increases risk and causes extra work. The next level sanction is not to exercise an optional extension. 

We often see longer contracts divided into an initial term with one or two extensions. For a 10-year contract, an initial term of four years with two 3-year extension is common. Having an off-ramp for an underperforming contractor seems like good risk management.  Here’s how it frequently unfolds.

Year one is often a transition-in period. Performance might be measured and discussed, but without any real impact.

Poor performance in Year 2 leads to candid conversations and promises to do better.  There might be marked improvement all round, which is great. It’s just as likely there is little real investment by the contractor, with perhaps some limited improvement. If poor performance continues into Year 3 the buyer decides not to extend and seeks approval to return to the market.

Corporate relationships go into overdrive. The vendor accepts some responsibility, but conversations with senior executives address misunderstandings, contributory factors, faults on the buyer’s side, and perhaps some allowance is sought for an over-enthusiastic contract manager.

Going to the market is an expensive distraction, introduces new risks, perhaps the new supplier will be worse, transition is considered problematic, as are the optics of contract failure. Everyone promises to do better, again.

The contract is extended for another term and the process repeated at the end of the extension period. Ultimately, the vendor ends up with a ten-year contract. Long term pricing and amortisation of start-up costs are calculated over the initial four year committed term.  The buyer pays four-year pricing, the vendor gets a ten-year benefit.    

Value for money is low and the risks of poor performance are not actually mitigated.

A case study

I was asked by a consortium, some years ago, to review an outsourcing contract. They were being hammered with service credits for underperformance. The contract was salvageable, but it would have taken investment across multiple service lines. Margins were already thin, and the consortium was unwilling to invest unless it could see higher returns through additional work that had been an enticement to contract and the best price. Given the poor performance, the buyer declined to offer that additional work until the contractual obligations met.

It was a Catch-22.

The Consortium decided to live with the reputation issues and the difficult contractual relationship, knowing the costs of remediation outweighed the value they would gain. The buyer lived with poor performance and a growing claim for service credits that were never fulfilled – for another six years!

Both parties were correct, and both lost.   

There is a better way

You, the buyer, must be on top of the game: professional, tough, knowledgeable, and agile. You need to be equal or better than the vendor. Not intransigent and argumentative, but thoughtful and strategic.

Implement KPIs with regular measurement and reporting. Measure yourself as well. a contract has mutual obligations, and you must create the conditions for the vendors success.  Do not be the cause of the vendor missing their performance outcome.

Avoid salami sliced performance payments linked to fixed KPIs over the contract life. Priorities and performance change and so too should your focus. You can have many points of measurement, but you don’t have to measure and report on all of them all the time. Ideally find measures that the company should already be collecting as part of running their business or project

Design a performance regime with flexible measures. Your expectation should be that the entire contract works, all the time. You should be able to look at different things at different times, and the vendor should be delivering. You can change points of measurement, though you might need to give some notice of the change.

Companies pay attention to that which you pay attention. Mix it up or the KPIs will be gamed. Aggregate the KPIs so that the effect of non-performance is felt.

An approach to consider

Here’s one approach that we have used that leverages the likely full term of the contract for a better price and delivers more leverage over lacklustre performance.

Consider awarding a 10-year contract at the outset but create the right to terminate early for non-performance. You will probably need to include, reasonably, a graded warning and chance to recover, but the effect on a company is enormous  Three of four years into a contract you might be having a conversation about terminating in a year or two, in your time frame at your choice., The company is no longer jumping an extension hurdle every 2-3 years it has to pay attention across the entire contract, continuity.

The leverage of the loss of 3-4 years of a committed contract is powerful. That’s a lot of lost revenue, for small companies and large. Depending on contract size, they may also have to report to investors, and I’ve seen such reporting influence share price.

This is a model that motivates management and Boards well beyond traditional salami sliced KPI based performance-payment frameworks.

There’s more

Traditional performance frameworks need a nudge. They look complex, scientific, but they are largely ineffective. There is also more to good contracting than a performance framework.

Problems don’t get fixed if they are ignored. You need good relationships to have difficult conversations – and a dose of personal courage. The relationship, as well as performance, needs managing. Something better than the usual 6 or 12-monthly, platitude filled “strategic” relationship meeting.

The key to finding performance measures that work, and contracting frameworks that deliver, requires intellectual agility and the knowledge to see the world from the vendors perspective. That knowledge is powerful, and hard to come by if your professional life hasn’t exposed you to the commercial world.

That’s why we developed our commercial acumen program – to provide that knowledge and insights into the commercial world for the public sector so that you can deliver better outcomes.

Talk to us about a program to develop your team, or for advice on structuring contracts that deliver successful outcomes.

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