One of the tenents of servitization is a move towards performance or outcome based services and contracts, in essence business transactions where compensation of the supplier is linked to the value (outcome) that is actually created. The idea has been around since 1972, when Theodore Levitt postulated that “customers don’t want to buy drills, they want holes in the wall”. Nevertheless the concept has been rapidly gaining ground over the last few years, as budget constraints in the public sector have forced buyers to look for ways to improve “bang for the buck” and/or reduce investment outlays and risks. A (2013) study by McKinsey on the US health sector estimated savings of up to US $ 1 trillion over the next decade by using outcome based contracting. Other studies have indicated similar results in the defense sector and there have been recent reports of paying for new expensive drugs based on avoidance of disease or reduction in disease incidence. In the energy services industry, performance contracting became the standard of practice by the mid ‘90s. Vendors would contract with customers to reduce energy consumption -usually by implementing energy efficiency investments and process changes- and get paid by the savings generated. Once the agreed payback (incl. profit) had been achieved the savings flowed to the customer. Undoubtedly this was a good deal for customers, it proved however not to be a good deal for many contractors and a decade later a large number had either gone bust or had scaled back significantly on the guarantees. It turns out that one of the weaknesses of performance / outcome based contracting (apart from standard problems like measurements and baselines) is how to assess and price risk. Because of course once the vendor is responsible for a longer term outcome rather than a straightforward delivery of a product or (standard) service, the risk (of the outcome happening) is shifted to the vendor. And there are two kinds of risk: i) the direct risk of performance, which arguably is more difficult for an outside vendor to manage, as he has to reach in to his customer’s value chain, thereby increasing complexity (and probably transaction costs) and ii) the indirect risk of moral hazard, i.e. the possibility that the customer’s behavior will become riskier –as he no longer carries that risk (anecdotal evidence abounds). To compound all this it should also be noted that performance risk assessment is not an easy undertaking, nor is the incorporation of risk into price. Often therefore pricing decisions tend to be arbitrary. The bankruptcies in the US energy services industry mostly came about due to intense competition which forced vendors to offer overgenerous terms and guarantees to customers, whether on actual performance of plant or on interest rates, due to overoptimistic risk assessments. They then suffered long-drawn out deaths, because the wrong pricing became evident only over time.
Performance / Outcome based contracts can offer significant benefits for customers and suppliers, most notably by aligning incentives, creating win/wins and reducing deadweight costs (i.e. used resources that create no value). They must however be managed with considerable care.
Over the next few weeks we intend to publish a comprehensive review of performance / outcome based contracting, including an analysis of pitfalls –which will also be available as a management guidance.
So please watch this space.
In the meantime we encourage readers to send us ideas, suggestions, opinions, examples or any other information they think relevant to make this more interesting. You can comment on this post or send us an email at email@example.com
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