“You get what you measure. Measure the wrong thing and you get the wrong behaviours.“
John H. Lingle
In our experience one of the most challenging steps in establishing a Performance Based Contract (PBC) is setting the performance levels for each performance measure.
In an earlier post (The Role of a Performance Measure) we established that the primary role of a performance measure was to communicate. Either communicate the buyers need (requirement) (e.g. what performance to I need out of this contract) or to communicate the sellers performance (e.g. did the required performance get delivered). The setting of performance levels simply continues this communication between buyer and seller.
Specifically, from a buyer’s perspective a performance level defines their performance requirements to the seller. However, for most PBCs it is not about setting a single performance requirement for each performance measure, but rather how rewards and remedies may change with the seller’s actual performance. For example, if the seller’s actual performance is worse than the buyer’s performance requirement, this would result in a reduced payment to the seller. Alternatively, and where there is benefit to the buyer, if the seller’s actual performance is better than the buyer’s performance requirement, this would result in an increased payment to the seller.
From a seller’s perspective, given the relationship between performance and rewards and remedies in a PBC, the performance levels represent a large part of the commercial risk and will be carefully considered by the seller. This is true of not only the performance level that results is 100% payment, but also for the performance level that results in 0% payment, and potentially the performance level that results in an incentive (e.g. 110% payment).
Before setting our performance levels we need to first define the 4 performance levels of a PBC as illustrated in Figure 1 below noting these levels equally apply to both quantitative performance and qualitative performance. These are as follows:
- Required Performance Level – this is the performance level the buyer expects delivered by the seller and should be the design point for the sellers solution (e.g. to make sure consistent ensure delivery of this level of performance to the buyer the seller needs an amount of staff, spare parts, vehicles, etc.). This typically represents the level where the buyer would pay the seller all (100%) of the performance fee against this performance measure.
- Minimum Performance Level – this is the performance level where the buyer receives no value from the service being delivered by the seller noting this point may not be ‘0’ performance (e.g. the buyer’s requirement may specify a minimum number (level) of emergency vehicles required each day as opposed to the minimum number being 0 vehicles). This typically represents the level where the buyer would not pay the seller any of the performance fee (0%) against this performance measure.
- Inflection / Elbow Performance Level – this is a performance level between the required and the minimum performance level and “shapes” transition from the minimum performance level to required performance levels. This can be a simple as a straight line between the two levels (e.g. linear), or as in the case for the Australian Department of Defence, this typically sits half-way between the minimum and required performance levels and represents the point where the buyer would pay the seller 80% of the performance fee against this performance measure. However, there are many ways of doing this.
- Incentive Performance Level – this is a performance level above the required performance level where the buyer may pay the seller more than the performance fee (greater than 100%) against this performance measure. However, paying an incentive usually only occurs where the delivery of superior performance delivers added value to the buyer and will usually be limited to a specific amount.
Having defined the 4 performance levels in a PBC, in the next post, we’ll discuss how to we set each.