In the previous article (see PBC Incentive Regime (Part 1)) I described the various benefits to both buyer and seller of having an incentive regime in a Performance Based Contract (PBC). In this article, let’s look at how to successfully make a PBC incentive regime.
Principles of a PBC Incentive Regime
To ensure a PBC incentive regime successfully delivers benefits I believe that we need to apply a number of principles as follows:
- Incentive Gate – payment of the full incentive will need the seller to be both eligible for payment, and assessed as having delivered ‘Superior’ performance against the incentive Key Result Areas (KRAs) noting these can be different to other KRAs. In some cases, eligibility may be linked to seller performance against other contractual aspects such as contractual / behavioural requirements such as Health, Safety Environment (HSE), anti-slavery, bribery and corruption (ABC), etc. sometimes called to a ‘hygiene’ factors referring to their minimal performance requirements.
- Minimum Performance – eligibility for the incentive is subject to general performance. That is, an incentive will be ineligible for payment where any of the KRAs are assessed as poor or not meeting minimum performance levels (i.e. there is no incentive available where one or more of the KRAs are assessed poor since under delivering in one area and over delivering in another area is not overall superior performance).
- Assessment Method – assessment of the amount of incentive payable will be based on metrics noting of course they could use qualitative / subjective performance measures (see Designing a Subjective Performance Measure (Part 1) and Designing a Subjective Performance Measure (Part2)).
- Maximum Incentive – there will be a cap (maximum) on the total amount of incentive available taking into account all incentives. For example, consider the effective profit rate achievable taking into (1) account base profit, (2) incentive and where applicable, (3) cost gain share, as a percentage of the actual costs. Alternatively, incentive funds may be reduced in specific circumstances such as the need to “top up” technical / project risk amounts, insurance claims, etc.
- Timing of the Incentive – in many cases incentives are tied to buyer financial years, however, sometimes a buyer (at their discretion) may move unearned incentives into later years.
- Multi-party Incentives – for multi-party (enterprise) incentives, the buyer will assess the enterprise performance and this performance score will apply to all organisations equally (e.g. the score applies equally to multiple sellers within the enterprise without adjudication).
PBC Incentive Key Success Factors
In addition to these principles, there are 3 key success factors required to deliver a successful PBC incentive regime; (1) aligning (targeting) incentives to buyer need, (2) balancing the amount of incentive on offer and (3) managing (calibrating) the expectation of getting the incentive. Let’s look at each in more detail.
1 – Aligning (Targeting) Incentives to Buyer Need
The first key success factor is aligning the incentive to the buyer’s need. This can be as simple as more performance against the current performance measures (e.g. faster delivery, less maintenance, etc.) or more complex (e.g. delivery of enterprise goals where the seller does not have total control of this outcome. Recent experience with large, long-term, strategic partnership PBCs highlight the need to think about enterprise performance and behaviours by using higher-level performance measures such as Strategic Performance Measure (SPMs) (see When is a KPI not a KPI?). This becomes critical where the incentive reflects the need for positive collaboration between multiple sellers in delivering the buyer enterprise goal.
Additionally, it is critical that the buyer can use (realise) the superior performance. For example, if the contract was for delivery of a spare part within 3 calendar days with incentives for early delivery. In this case, should an incentive be paid for early delivery of a part to the buyer’s site on a Sunday when no one is there to accept it? What benefit has been realised? Indeed, it may cost the buyer the have people on-site to accept the part early.
Finally, it may be possible to change the incentives on a semi-regular basis to make sure that they target the changing need of the buyer. While this makes the contract management more complicated, for long-term strategic partnerships this re-setting of incentive offers benefits to both buyer and seller (see Changing Performance Measures).
2 – Balancing the Amount of Incentive on Offer
The second Key Successful Factor is the size of the incentive. So how much should be offered? Rather than this being a simple formula, the key is balancing the risk / reward structure for the entire contract. Many, especially sellers, like the idea of symmetry between the At-Risk Amount (the amount put at risk for performance typically reflecting the profit margin) and the incentive. For example, a 10% At-Risk Amount (ARA) (and therefore 10% profit) would then result in a 10% incentive. While the seller may like this, for the buyer, and especially those in the public sector organisations (e.g. state and federal governments), a potential 20% profit margin is hard to defend when subject public scrutiny. That is, unlike the private sector, many state and federal governments must contend with audit offices, routine governmental hearings and extensive media coverage. Accordingly, paying an incentive should pass the simple question of “what benefit is the government getting for the extra money given that they have a contract?”.
3 – Managing (calibrating) the Expectation of Getting the Incentive
Finally, in my experience it is critical for a good relationship that both buyer and seller are aware of the expectations of either paying or receiving an incentive, beyond the principles described above. Some of these points are described below from each perspective.
- Incentive Reflects Additional Effort, not Luck – that is, incentives should reward the seller’s extra effort to deliver superior performance as opposed to simple luck. While luck may still occur, it shouldn’t be recognised as effort needed to deliver superior performance.
- Chance of Getting the Incentive is related to the Size of the Incentive – that is, if superior performance is hard to deliver, and is unlikely the result of luck, the size of the incentive should be relatively larger than superior performance that is simple (easy) to deliver.
- Total Incentive not Guaranteed – that is, the incentive is not an “all or nothing” proposition, but rather the amount of the incentive payable will vary based on how much of the superior performance is delivered. Moreover, that the amount payable is still subject to any eligibility criteria (see PBC Incentive Regime (Part 1)) and delivery of minimum performance.
- Is it achievable (Achievable vs. Stretch Goal) – In a previous article (see Stretch Goals) we examined research showing for an incentive to work the seller must have a chance of getting it. It also showed that where there is no chance, regardless of effort, it has a negative effort. Moreover, where the superior performance is hard to deliver, the amount of the incentive should be larger.
- Return on Investment (RoI) – that is, the amount of effort has a positive RoI. For example, many years ago when working with a large client in the United States we determined that the amount of the incentive on offer was large (e.g. $1 million dollars). Unfortunately, based on our estimates, it would have taken $6 million dollars to earn the $1 million dollars resulting in a net $5 million dollar loss. Clearly not a good financial outcome for the seller.
In summary, the deliberate and careful use of incentives in PBCs can deliver benefits to both buyer and seller. They can encourage and reward the delivery of positive collaborative behaviours and long-term / enterprise outcomes. The key to the successful application of PBC incentives is aligning (targeting) incentives to buyer outcomes, balancing the amount of incentive on offer and managing (calibrating) the expectation of getting the incentive. If you can achieve all this, the outcome of your PBC may exceed your expectations. And that is a great outcome!
Pingback: Reliability in Performance Based Contracts (PBCs) – Part 2 | Performance Based Contracting (PBC) Blog