In an earlier blog I had mentioned consequence analysis as a method for determining the commercial risk to buyer and seller to avoid the all too common feeling towards Performance Based Contracts (PBCs); that they are riskier than conventional contracts due to their very nature (i.e. performance based). This blog highlighted that to avoid this “performance anxiety” we should decide whether this risk is real, or whether it perceived due to an emotional response from being performance managed. In the next two posts let’s look at what is a consequence analysis and how does it help?
Before we look at consequence analysis in detail we first need to define what commercial risk is with respect to a PBC. In this case, and noting that risk is a combination of likelihood (chance of occurrence) and consequence (action if the event does occur), then the commercial risk is:
- from a buyer’s perspective – the PBC does not drive the right behaviour and/or does not provide adequate commercial protections for the buyer potentially resulting in 100% payment regardless of performance; or
- from a seller’s perspective – the outcome of the PBC is not achievable or is highly sensitive to variation in performance resulting in very low, if any, payment and perception of being punitive.
Given this, in my observation most practitioners focus on what consequences can be applied due to a failure to perform (e.g. reduction in profit, no contract extensions, etc.) and not what consequences are likely to apply. In many cases practitioners over-estimate the risk by focusing on the consequences deterministically (that is, that they will occur during the term of the contract) not probabilistically (that is, what is the chance of this event occurring during the term of the contract). In fact, many of us are trained to think that way in trying to find what are the worst outcomes that can occur under this contract.
Accordingly, the role of a consequence analysis is to undertake a probabilistic risk assessment of the PBC in terms of both the likelihood and consequences of the various requirements and associated rewards and remedies that apply. The aim of a consequence analysis is threefold:
- calculate the likelihood of payment given historical performance and contract terms;
- set up the various performance measures and the required performance to return a specified payment; and
- provide knowledge during contract negotiations to minimise the commercial risk.
In order to do this we now need to look we need to now look at the likelihood for each performance measure either using historical performance data or by estimating future performance. This likelihood is then applied to the various rewards and remedies to calculate the real risk. But how we do this is for the next post.