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).

This entry was posted in Behavioural Economics, Nudging, the How, the Why and tagged , , , , , , , . Bookmark the permalink.

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