Inputs, Output and Outcomes – Part 2

In the previous article (see Inputs, Output and Outcomes – Part 1) I looked at the difference between inputs, outcome and outcomes from a Performance Based Contracting (PBC) perspective in order to highlight the benefits and pitfalls of this approach.  However, we didn’t look at how you could response to this challenge by aligning both collective and individual requirements (i.e. the performance measures) with specific rewards and remedies (i.e. the consequences).

Acknowledging the difference in 2012, the Australian Department of Defence created three tiers of performance measures to reflect input, outputs and outcomes with the later named Strategic Performance Measure (SPMs).  Each of the tiers of performance measures are linked to different levels of commercial rewards and remedies reflecting this concept of input, outputs and outcomes.  Figure 1 highlights the relationship among each of these with the definitions provided in Table 1.

Performance Measure Tiers

Figure 1 : Performance Measure Tiers

Item Definition Commercial Consequences
Strategic Performance Measure (SPM)

OUTCOME

Performance measures that reflect “enterprise” (end customer) outcomes; that is, the highest-level outcome acknowledging that the seller may not be solely accountable for failure or success of this outcome. Given the indirect nature of SPMs, they are typically not linked to money, but rather to other non-monetary rewards and remedies.
Key Performance Indicator (KPI)

OUTPUT

Performance measures that are directly related to seller performance against their individual scope of work where they have sole accountability; outputs. Given the direct linkage of a KPI to Contractor performance KPIs are linked to money resulting in them being quantitative and lag in nature.
System Health Indicator (SHI)

INPUTS

Performance measures that give insight into past and future seller performance by highlighting drivers and constraints to this performance.

Typically, the role of a SHI is to provide confidence in the delivery of the KPIs.

Given the indirect nature of SPMs, they are typically not linked to money, but rather to other non-monetary rewards and remedies

Table 1: Definition of Tiers of Performance Measures

Solution:  Both buyers and sellers need to acknowledge the difference between inputs, outputs and outcomes to ensure the expectations and commercial models are aligned.  It is critical that everyone fully understands the differences in their roles and responsibilities.  However, many organizations, similar to our online grocery delivery example, find it difficult to accept the consequences of holding organizations accountable for a shared, end customer outcome as opposed to individual output.  This is especially true when commercial remedies are involved such as reduced payment or service contracts.  The key is for both buyers and sellers to align their understanding and expectations of their individual contract output with that of the end customer (enterprise) outcome, and how and when the various commercial consequences apply.  Specifically, this includes:

  • what the seller is directly accountable for (e.g. outputs),
  • what shared responsibility all organizations have when delivering outcomes; and
  • aligning the commercial consequences, both positively (rewards) and negatively (remedies) with these different tiers of performance measures.

Our ever increasingly complex, interwoven commercial relationships and supply chains require more clarity of what success looks like and to whom.  Moreover, as stated earlier, although the move to outcomes is laudable, both buyers and sellers need to acknowledge the difference between inputs, outputs and outcomes to ensure the expectations and commercial models are aligned.

So, when next confronted with an “outcomes based contract” asked yourself whether the contract is asking for inputs, outputs or outcomes, and whether the commercial rewards and remedies align with them.  If not, we just may get oranges instead of apples; and who’s fault would that be?

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Inputs, Output and Outcomes – Part 1

Much has been said about outcomes recently.  Indeed, many buyers seek to use Performance Based Contracts (PBCs) to contract for outcomes, because they are attracted by the simplicity of using a PBC.  But this could be a costly mistake if you do not first carefully plan, set up and execute the requirements of your PBC.

Planning and correctly executing starts with defining what result, or outcome, you desire then evaluating the performance measures defined in the PBC specifically relating to input, outputs, and outcomes.

A PBC – being different from a conventional contract – is designed to reduce overall costs for buyers and provide profitable growth opportunities for sellers.  We tend to view the PBC as the contract model of choice across a range of market sectors.  The ability of organizations to effectively develop, implement and manage PBCs is critical to business success, because failure can often lead to long-term performance, financial and reputational damage.

The following two-part article explains how PBC contracting works and why focusing only on outcomes only is a mistake.  Why is it critical for buyers and sellers to first identify and understand all inputs and outputs?  Only then can they better define the overall outcome (success) as seen by the end customer.

The first step is to clarify whose outcome — the direct outcome of the trading (or partnering) relationship or the outcome as experienced by the final customer.  Will your idea of a successful outcome vary with a change in perspective between – or among – various trading relationships?

To illustrate how an outcomes varies depending on your perspective picture your grocery store’s online ordering system.  You select, order and have delivered a range of grocery items like fruits and vegetables.

Delivering your order requires a number of organisations each with individual roles and responsibilities, and a specific sequence as follows:

  • Step 1 – End Customer (you) selecting groceries, defining the delivery date; paying the bill; and being home for the delivery.
  • Step 2 – Information technology organisation ensuring the grocery ordering website, including the payment system, is available for the end customer, supermarket staff and transportation staff to document orders and deliveries.
  • Step 3 – Grocery suppliers like farmers suppling all types of groceries to the supermarket based on the orders being placed to ensure there is sufficient stock available.
  • Step 4 – Supermarket selecting the items you order online and loading them into containers for delivery. It’s ready to go!
  • Step 5 – Transportation organisation taking groceries from the supermarket and delivering them to you.

Figure 1 shows the variety of organisation and their specific roles and responsibilities involved in delivering your order, in good condition, for the correct price at the agreed date / time, to you as the end customer.

Grocery Home Delivery Enterprise

Figure 1 : Grocery Home Delivery Enterprise

As figure 1 illustrates, the process can be complicated, because many commercial organizations who are expected to get the groceries to you on time are not solely accountable for final success of that delivery to you the end customer.  So, if you are contracting out the grocery transportation process, what is their outcome?  Is it simply successfully delivering all groceries provided by the previous step, the Supermarket, in full and on-time without breakage?  Or is it the end customer satisfaction, which may also depend on the farmers or the IT organisation?  Which I right?

One method we use to help understand this difference in perspective is by describing the inputs and outcome to an individual organization, and then comparing to the end customer outcome.  Here I use inputs and outputs to reflect the lower level organisation or process activities that as a total then make up the end customer outcome.  Indeed, how all these inputs and outputs fit together to deliver the end customer outcome highlights the various interdependencies between the organisations.

One technique to help identify the relationship between inputs and outputs is to use consider using the Integration Definition for Function Modelling (IDEF0).  Figure 2 describes a standard functional process block including four elements: inputs, output, mechanism (resource) and control.

Integration Definition for Function Modelling (IDEF0) Functional Process Block

Figure 2 : Integration Definition for Function Modelling (IDEF0) Functional Process Block

Like other modelling approaches and tools the intent of IDEF0 is to provide a structured representation of the functions, activities or processes within the modelled system or subject area.  Using the IDEF0 model, we can quickly identify whether we are measuring an input (something that enters the process) or an output (something that exits the process).

Let’s consider our grocery example again, and specifically the transportation organisation, which in this case we will contract out.  Here, Figure 3 describes the input and outputs.

IDEF0 Functional Process Block Representation of Online Grocery Delivery Contract

Figure 3 : IDEF0 Functional Process Block Representation of Online Grocery Delivery Contract

NOTE:  Figures 2 and 3 correlate:  Consumer law and Labour law represent Control; Packed grocery items and delivery represent input; Vehicle for delivery and delivery staff represent Mechanism (resource) and Grocery delivery is the outcome.

However, where is the outcome?  More importantly, can the transportation contractor be held solely accountable for an end customer outcome?  For example, if the Supermarket accidently packs oranges instead of apples, and these are delivered, who is at fault?  All will agree that the end customer outcome has not been achieved, but where is the fault?  Importantly, how do we treat this where there are commercial consequences, such as reduction in payment?

In the next article I will talk about one organisation’s response to this challenge by aligning both collective and individual requirements (i.e. the performance measures) with specific rewards and remedies (i.e. the consequences).  In the interim, I look forward to hearing your thoughts on this very interesting topic.

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The Mathematics of a Performance Based Contract (PBC) – Part 2

In the previous article (see The Mathematics of a Performance Based Contract (PBC) – Part 1) I described how a standard Australian Department of Defence Non-Linear PBC Payment Curve could be described by 2 equations for straights lines of the form:

y = mx + b

Accordingly, from a PBC perspective this equation can be rewritten as:

APS = m (Achieved Performance) + Minimum APS Value

The hardest calculation is to determine ‘m’, the slope of the curve.  However, we can simply think of it as “if my Achieved Performance increases by say 1 percentage, how much does the APS go up by?”  In mathematics this is typically written up as:

where:

  • Rise = change in the APS over the length of the line
  • Run = change in the Achieved Performance over the length of the line

Again, if you are a little rusty, you may want to have a look at the following website (see https://www.mathsisfun.com/gradient.html).

Consider the example in Figure 2.

Example Non-Linear PBC Payment CurveFigure 2 – Example Non-Linear PBC Payment Curve

For Performance Band C the gradient would be:

That is, for each 1% increase in the Achieved Performance score from 85% to 90%, the APS would increase by 16%, from 0% to 80%.

Alternatively, for Performance Band B the gradient would be:

That is, for each 1% increase in the Achieved Performance score from 90% to 95%, the APS would increase by 4%, from 80% to 100%.

So why have I done all this maths?  What is the point?

In operation, say the seller achieved an Achieved Performance score of 87%, what would be the corresponding APS?  In this case, using the equation we derived above for Performance Band C we can simply put in the value of 87% as follows:

APS (Performance Band C) = 16 x (APS – 85%) + 0%

= 16 x ( 87% – 85%) + 0%

= 16 x (3%) + 0% = 48%

Therefore, an Achieved Performance score of 87% is equal to an APS of 48%.

Importantly, you will notice an additional term in the equation above, specifically (APS – 85%). The reason for this is to have the same ‘range’, or distance, that the ‘run’ had in calculating the gradient; that is between 85% and 90%.  Therefore, we need to subtract 85% from the Achieved Performance score before multiplying by the gradient.

Alternatively, say the seller achieved an Achieved Performance score of 94%, what would be the corresponding APS?  In this case, using the equation we derived above for Performance Band B we can simply put in the value of 87% as follows:

APS (Performance Band B) = 4 x (APS – 90%) + 80%

= 4 x ( 94% – 90%) + 80%

= 4 x (4%) + 80%

= 16% + 80% = 96%

Therefore, an Achieved Performance score of 94% is equal to an APS of 96%.

Again, you will notice the additional term in the equation above, specifically (APS – 90%) giving the same ‘range’, or distance, that the ‘run’ had in calculating the gradient; that is between 90% and 95%.  Therefore, we need to subtract 90% from the Achieved Performance score before multiplying by the gradient.  However, in this circumstance, the APS had a starting value of 80% and therefore we had to add 80% to the final score.

By being able to do this maths both buyer and seller can determine the APS for each performance measure, and in some cases, determine the payment.  Accordingly, it is important for PBC practitioners, regardless of whether buyer or seller, to be able to understand and complete these calculations.

In the next article we’ll look at an alternate option to using this maths.

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How to Successfully Manage a Performance Based Contract (PBC) – the Prequel

I get many questions from readers of the blog on how to successfully manage a Performance Based Contract (PBC) including what are the critical areas that they need to be aware of.

While many of my posts including discussion points on how to undertake contract management, like the recent one of PBC Mathematics, as an International Association for Contract and Commercial Management (IACCM) Fellow I have in the past provided a guest lecture (webinar) specifically on how to successfully contract manage a PBC as part of their free online Contract Management Course.

If you were not aware, IACCM is again offering this free online Contract Management Course to everyone. The course was developed by IACCM in partnership with the University of Southampton, the UK Cabinet Office and Civil Service Learning.  The course is run over a 3 week period starting on 7 October 2019.

You can get more detail at https://www.iaccm.com/events/register/?id=3511.  You may even see me there!

That said, I will be releasing an article on this topic before the end of the calendar year.

Disclosure – I am an IACCM Fellow and part of the Australia and New Zealand Advisory Board for IACCM.

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The Mathematics of a Performance Based Contract (PBC) – Part 1

Over the 15 years of applying and teaching Performance Based Contracting (PBC) I have always had trouble trying to describe the mathematics of PBCs, especially to those who

Reminded by my family’s current viewing of the US TV Series, Numbers, I am inspired to try and make PBC mathematics more accessible in order for non-mathy people to better understand, and hopefully use, these techniques.  So where is maths used in a PBC?  Interestingly, it is used throughout a PBC, from the performance levels to the percentage weighting of each of the say three Key Performance Indicators (KPIs) (e.g. 50% for KPI-1, 30% for KPI-2 and 20% for KPI-3) through to adjustment of the performance fee / At-Risk Amount.  However, for the majority of circumstances, the math in these instances is fairly simple and doesn’t tend to worry most people.  But there are two areas where this isn’t the case:

  1. working out the Adjusted Performance Score (APS) from an Achieved Performance score for a non-linear payment curve; and
  2. using historical data to set a performance level.

In these instances while the maths is fairly simple, they tend to confuse people leading to either avoidance by using an alternate approach which doesn’t require the same level of mathematical ability or removal altogether.  So let’s look at each in turn starting with the Adjusted Performance Score calculation.

Calculating the Adjusted Performance Score (APS) in a Performance Based Contract

In a series of previous articles (see Payment Curves Part 1, Part 2 and Part 3) I highlight the various methods for describing how to turn an Achieved Performance score (i.e. the raw score of the performance measure such as number of days late from a milestone, percentage of satisfied deliveries, number of outages per 1,000 operating hours, etc.) into an APS, which is always a percentage.  While there are a number of ways of doing this, a common method is to use a straight line between the minimum performance level (at which APS = 0%) and the required performance level (at which APS = 100%).  This can be a simple straight line between these 2 points, or as in the Australian Department of Defence approach, this line is broken into 2 segments with an inflection / elbow point making it two lines. However, the issue remains the same, how do I calculate the APS from the Achieved Performance score based on the straight line?

Consider the generic non-linear Payment Curve described in Figure 1 which has four “bands” of performance.

Generic Non-Linear PBC Payment CurveFigure 1 – Generic Non-Linear PBC Payment Curve

Here, all but Band D has a requirement to do some maths in order to determine the APS from the Achieved Performance level using the equation for a straight line:

y = mx + b

where:

  • y = Adjusted Performance Score (APS), or the vertical axis of the payment curve in percentage
  • m = gradient of slope of the line – the lower the value of m the less steep the line, while a higher value of m results in a steeper line
  • x = Achieved Performance score, or the horizontal axis, in whatever scale (e.g. percentage of satisfied deliveries)
  • b = starting or ‘offset’ point which is the value for y when x = 0 (e.g. for Band B the minimum APS is 80%, therefore z = 80%)

If you are a bit rusty you can get more information from the following website (see https://www.mathsisfun.com/equation_of_line.html).

In the next article I will look at how we apply this to a PBC using an example from the standard Australian Department of Defence Non-Linear PBC Payment Curve.

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How to Nudge a Performance Based Contract (PBC) – Part 2

In the previous article (see How to Nudge a Performance Based Contract (PBC) – Part 1) I described how successful contracts deliver the desired outcomes of both buyers and sellers; the classic “win-win” outcome that we all strive for.  We achieve this outcome by balancing the requirements of both buyer and seller with the consequences (rewards and remedies) that provides both positive (carrot) and negative (stick) incentives.

Examining the relationship between the three areas described in Figure 1 of Part 1 (Buyer Need, Seller Need and Commercial Construct), as illustrated in Figure 1, it is possible to observe the following characteristics:

  • moving horizontally (left / right) changes the nature of the agreement; the left-hand edge is a conventional commercial construct transferring risk from buyer to seller through a prescriptive, written contract whereas the right-hand edge is a highly collaborative (relational) approach that shares commercial risk between the parties with limited formal detail; and
  • moving vertically (up / down) changes the outcome for both the buyer and seller; the top edge meets the Buyer Needs but may be seen by the seller as punitive, “unfair” and a “bad deal” whereas the bottom edge meets the Seller Needs but may be seen by the buyer as risk free providing no assurance of performance; “money for nothing”.

Figure 1 : Relationship between Seller Need, Buyer Need and Commercial Construct

Acknowledging these extreme edges, the ideal PBC is one that balances each of these three areas represented by the overlapping region in the centre of the diagram where the Buyers Needs are delivered by linking these to the Sellers Needs through a fair collaborative Commercial Construct.

So how do we achieve this balance?

A PBC is fundamentally a behavioural economics approach where the buyer is trying to “nudge” seller behaviour to deliver their outcome by applying range of complementary rewards and sanctions.

Those familiar with Thaler and Sunstein’s concept of nudging may disagree with my analogy since 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 direct legal consequences of a conventional contract such as contractual breach.

While this type of nudge is more direct than Thaler and Sunstein probably envisioned, perhaps we can call it a “heavy nudge”, I believe the intent is same.  Moreover, I believe those of us involved in developing PBCs should strive to deliver a PMF that allows a seller to self-regulate their own behaviour by defining the consequences of their actions or omissions, including positive rewards (incentives), for delivery of the required outcomes.  One of the ways of achieving this is by designing our Commercial Construct with a range of consequences that scale (escalate) based on significance of performance variation from our requirements, in terms of duration, impact of the variation on the buyer, and whether this represents a continuing / repeating performance issue. This approach can be seen in Table 1.

Commitment
(Disable Choice)
Incentive
(Guide Choice)
Positive Incentive (Carrot)
  • Contract Duration and Extension
  • Incentives
  • Recognition schemes
Negative Incentive (Stick)
  • Stop Payment
  • Termination
  • At-Risk Amount
  • Liquidated Damages

Table 1 : Typology of Incentives and Commitments[1]

Here, 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 choice; does the consequence disable or merely guide choice.

For organisations that want to minimise the variation between PBC, one approach used with good results is to simplify contract drafting by codifying a default Commercial Construct that includes a range of consequences that scale (escalate) based on significance of performance variation from the buyer’s requirements.  The Australian Standard for Defence Contracting (ASDEFCON) suite of contract templates[2]are one example of this approach.

In summary, when commercial practitioners are developing their contracts they should be mindful of the field of behavioural economics ensuring their “Choice Architecture” delivers a fair and balanced commercial construct that delivers both the buyer’s and seller’s needs.  If commercial practitioners can do this, it should lead not only to positive outcomes, but also to positive and supportive behaviours.  And who wouldn’t want this!

[1]                Adapted from AYRES, I. “Carrots and Sticks”, Bantam, 2010

[2]               http://www.defence.gov.au/casg/DoingBusiness/ProcurementDefence/ContractingWithDefence/PoliciesGuidelinesTemplates/ContractingTemplates/asdefcon.aspx

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How to Nudge a Performance Based Contract (PBC) – Part 1

Commercial instruments, especially sophisticated ones such as Performance Based Contracts (PBCs), have the ability to shape the behaviour of both buyer and seller.  While many commercial practitioners see contracts in their simplest form, an explicit and directive agreement between buyer and seller, some acknowledge that contracts can be used for much more.  At their best, contracts can define, shape and nudge positive outcomes, including behaviours, in both buyer and seller.

In 2008 Richard Thaler and Cass Sunstein published, Nudge: Improving Decisions about Health, Wealth, and Happiness, which used behavioural economics as a method for helping people improve their decisions.  This book has had a profound impact on the field of economics introducing the notion of designing choice architectures to help people make better decisions by predicting how humans behave in certain situations.  Moreover, they gave us a blue print of how we could use various economic instruments to “nudge” human behaviour.  This is achieved by designing a “choice architecture” allowing individuals to choose their own path while highlighting the advantages and disadvantages of each choice; termed liberal paternalism.

Since this early description there have been many uptakes of the “nudge” approach including the creation of Behavioural Insight Teams (BIT)in a number of countries helping various local, state and federal governments design, modify and apply policies. However, applications are typically not focused on activities involving commercial contracts.

Despite the success of the book and the concept there are a number of proponents that disagree with the approach.  Some feel that providing a nudge towards a particular choice is itself a form of bias, and more extreme commentary claiming it is removing choice from the individual, even if offered.

So why am I bringing this up?

In the early 2000’s a number of organisations, especially in the Defence sector, began using Performance Based Contracts (PBC), or sometimes referred to as Performance Based Logistics (PBL) contracts or Contracting for Availability, with the intent of improving performance at a decreased price.  Indeed, the ability for a PBC to simultaneously deliver these outcomes[1][2][3][4]          has seen them more popular and their use more widespread.

Performance Based Contracting (PBC) 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 their accomplishment of measurable and achievable performance requirements.

But for many people designing and applying PBCs over the past decade will see similarities between the concept of nudge and the intent of a PBC.  That is a highly successful PBC will:

  1. drive the right behaviour in the seller by addressing the Seller Needs;
  2. provide adequate commercial protections for the buyer by addressing the Buyer Needs; and
  3. balances both these needs within a usable Commercial Construct.

Accordingly, a good PBC aligns the Seller Needs against delivery of the Buyer Needs that is described in the Commercial Construct. Figure 1 highlights the interaction between these three areas based on, an asset management scope of work where:

  • Buyer Needs represent the traditional specification of requirements. In sustaining Complex Materiel[5] these requirements can be grouped into three broad areas of Asset Usage, Asset Optimisation and Asset Preservation underpinned by Safety Culture, Cost Consciousness and Positive Behaviours.
  • Seller Needs 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 the agreement, typically a contract, between the parties that fairly motivates and delivers both Buyer Needs and Seller Needs. The optimal Commercial Construct is a balance of conventional (written) contracting protections and a collaborative (relational) contracting approach.

Figure 1 : Interaction between Seller Need, Buyer Need and Commercial Construct

In order to achieve this 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.”

However, it is more than simply the Key Performance Indicators (KPI), but rather how all facets of the contract fit together to drive behaviour.  Indeed, key to the successful operation of the PBC is the notion of self-regulation where the seller’s performance determines the commercial consequences; positive or negative.  This idea of self-regulation aligns with the Behavioural Economics notion of “nudging” where, rather than the buyer directing the seller exactly how to deliver the outcome, the PMF should “nudge” the seller’s decisions allowing choice in full knowledge of the buyer’s requirements and consequences of the seller’s actions.

[1]            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

[2]            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

[3]            “Performance & Outcome Based Contracts 2015”, International Association of Contract and Commercial Management (IACCM), 2015

[4]       DOOGAN, C., LINGER, H., HOLMES, D. and BJERKNES, G., “Enquiry into Performance Based Contracting Practice – Phase 2 Case Studies”, June 2018

[5]       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).

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