Award Term – Part 2

In the earlier post (see Award Term – Part 1) I looked at the key elements of an Award Term.  In this post let’s look at how the buyer determines whether to grant an Award Term to the seller.

Award Term Assessment Method

Before considering the assessment criteria there are 3 methods that can be used to decide whether an Award Term should be granted.   While each of these 3 methods are valid, the need to seek a fair position for both buyer and seller has led to an increased used of the ‘Balanced’ method described below as it offers a good mix of flexibility and transparency.

Award Term Assessment Method Advantages Disadvantages
Balanced – where the Award Term is granted based on a combination of specified general rules and buyer discretion
  • Provides seller clarity on the requirements and process for an extension
  • Allows buyer discretion to grant an extension
  • Discretion based on human judgement
  • More complex contract drafting than Qualitative approach

Award Term Assessment Method

Award Term Assessment Criteria

In addition to the assessment methods the buyer will need to develop the Award Term assessment criteria. A couple of years ago a senior executive once joked that from the buyer’s perspective that the Award Term assessment criteria were two simple questions; (1) do I still love you? and (2) can I still afford you?  Humour aside, the intent of these two questions is sound.  Firstly, is the seller’s both performance and relationship / behaviours still delivering the buyer’s outcome (i.e. am I still in love)? Secondly, has the seller improved the value of the contract by reducing the price of the services or improving / increasing the scope of the services (i.e. can I still afford you)?  The message, while silly, is simple; for a contract extension to be granted the seller needs to deliver good performance supported by positive, collaborative behaviours and improved value for money over the life of the contract.

The table below provides further Award Term assessment criteria based on the Support variant of the Australian Standard for Defence Contracts (ASDEFCON) contract templates.

Core Award Term Assessment Criteria
(Seller . . .)
Optional Award Term Assessment Criteria
  • performs obligations in a way that satisfies the Contract objectives;
  • behaviours have positively contributed to seller performance;
  • performance against each financial performance measure for the review period is assessed as meeting or exceeding the contracted level of performance; and
  • performance against all non-financial performance measures is assessed as meeting or exceeding the contracted level of performance.
  • outcome of any cost review is assessed as acceptable.
  • no Remediation Plan required during review period, or if one has been raised, the seller has completed all steps to the satisfaction of the buyer.

Core and Optional Award Term Assessment Criteria

Importantly, as these contract extensions reflect additional price to the buyer, it is recommended that any Award Term determination occur before the buyer’s annual budget cycle to allow this price, and any variation, to be included in the buyer budget for the next Financial Year.  This may need the Award Term determination to occur many months before the end of a financial period since in many organisations, especially large organisations, the budget cycle can be up to 4 months earlier.

In the last post of the series I will look at 3 examples to hopefully aid the understanding and practical application of this Performance Based Contracting approach.

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Award Term – Part 1

Central to the use of Performance Based Contracts (PBC) is the balancing of buyer needs with seller (contract) consequences, referring to the variety of commercial rewards and remedies that apply as part of a PBC and can include contract extension, payment, remediation plans, stop payment, contract termination, etc.

One of the main incentives used in PBCs is the awarding of additional contract duration (or term) for good or superior performance.  This additional tenure, called an Award Term by many PBC practitioners, is the process that determines whether additional contract duration will be granted.  While Award Term is the label generally used in Australia, other labels include Rolling Wave or Rolling Window, both highlighting the reoccurring nature of granting of contract extensions.

Over the next few blog entries I will discuss what an Award Term is, including key features, and how to use them.  At the end I will give some scenarios to illustrate how they work.  So how does an Award Term work and what are the key features?

The key elements of an Award Term contract are as follows:

  1. Initial Term– this is the base duration of the first contract and for many long-term contracts (greater than 10 years) the initial term will typically be between 5 – 7 years. For shorter-term contracts (less than 10 years) this will typically be 3 years.
  2. Maximum Term– if all Award Terms were granted, this is the total contract duration.
  3. Award Term– this the duration of the extension that, when granted, will cumulatively add onto the initial term. The size of the duration balances the cost associated with assessing and granting the Award Term with the need to keep the seller motivated by having Award Term assessments.  While many Performance Based Contracts will use the simplicity of a fixed extension duration of 1 or 2 years, many advanced Performance Based Contract will use a variable Award Term.  For example, using a variable Award Term the buyer could initially grant only a 1-year extension.  Once the seller has proven their performance, the buyer could grant a 2 or 3 year extension instead.  Should the seller’s performance reduce, the buyer can either go back to shorter extensions (e.g. 1 year) as a form of performance probation or not grant an extension.
  4. Off-Ramp Date– is the date where the buyer will automatically begin a retendering activity for either all or some of the contract scope. This date is set by allowing the buyer sufficient time to undertake a retendering activity before expiry of the current contract. For many large contracts, this can be between 1 and 2 years.  For many government agencies, this will be 2 years.
  5. Initial Award Term Assessment Date– is the date where the buyer is first assessing the seller for a contract extension. Typically, it is at least 2 years before the Off Ramp Date to allow the seller at least one failed Award Term Assessment before the buyer commences a retendering activity.

To help illustrate these elements and their sequence consider the example shown below.  In this example, consider a large contract that provides a range of support services to a buyer including maintenance, logistics and training.

award-term-generic.png

Example Award Term Performance Based Contract

Firstly, given the large scope of the contract, it is likely that the initial term of the contract would be at least 6 years and has a maximum term of 15 years.  Additionally, the buyer has sought internal funding for $150 million based on the assumption that the price per year was $10 million up until the end of the Maximum Term.  However, it should be remembered that the seller is only entitled to $60 million as that is the price of the initial term of the contract.  Any additional contract term, and therefore price, will need to be earned through the Award Term process.

Secondly, given the complexity and size of the contract it typically takes the buyer 2 years to undertake a complete tendering process from writing the tender through waiting for a response, evaluation, negotiation and signature, the buyer has set the Off-Ramp Date at 2 years from the end of the Initial Term.

Finally, to allow at least two assessment periods between the initial Award Term Assessment date and the Off-Ramp Date, the Initial Off Ramp Assessment Date has been set 2 years earlier than the Off-Ramp Assessment Date.

In the next entry we’ll look at the assessment methodology for whether an Award Term is granted.

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Comparing Performance Across Cultural Divides

As part of teaching in the United Kingdom (UK) one of the attendees mentioned a common issue found in Performance Based Contracting (PBC); the wish to compare performance across cultural boundaries.  In this case the attendee mentioned their organisation was using a Net Promoter Score performance measure to compare performance of a UK and US part of the same organisation.  A Net Promoter Score performance measure is one that uses feedback to a single question: How likely are you to recommend our company/product/service to a friend or colleague?  The scoring for this answer is most often based on a 0 to 10 scale.

In this case the US part of the organisation was getting 9.8 out of 10; unquestionably, a great good score.  However, the UK part of the same organisation was only getting 8.8 out of 10.  So why the difference?  Initially, most people will believe that the UK part of the organisation is simply not performing as well as the US part.  However, is this true?

Culturally, people from the US are more likely to give full scores (i.e. 10 out of 10) for excellent performance.  Therefore, the 9.8 out of 10 is possible.  However, regardless of the same excellent performance, people from the UK will not give 10 out of 10 since, culturally, they believe even excellent service can be improved.  Therefore, they must leave room in the score to improve, intending to drive future improvement.  Hence, 9 out of 10, and the average of 8.8 instead of 9.8.

When the UK attendee asked their clients whether there was anything else they could do to improve the performance to a 10, the answer was ‘no’. When the attendee questioned why they didn’t score 10 out of 10, each client simply stated they could not give a 10 out of 10 just in case the performance got better.  However, they were completely satisfied with the services delivered with attendee not being able to do anything better.  A score of 9 was simply the best they could give.

Many of you reading this may believe this is a story; a parable to help explain the cultural issues. However, it is true, and importantly, not an isolated instance.  Accordingly, PBC practitioners need to be careful when directly comparing performance scores between cultures.

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Perverse Incentives – Part 2

In the previous article (see Perverse Incentives – Part 1) I discussed why PBC practitioners need to be aware of the potential for perverse incentives in our PBC arrangements.  In this article let’s look at how PBC practitioners, both buyers and sellers, can avoid accidentally including perverse incentive. In a previous article (see Unintended and Perverse Outcomes) I looked at a couple of recent cases that highlighted some possible actions.

From the buyer’s perspective, this requires “testing” of the PBC to see whether the Performance Management Framework (PMF) works as intended based on the three tests described above. You can undertake this testing by:

  • testing the arrangement for all areas of performance, from 100% (or above if incentivised) to 0% performance, observing what conditions result in this, and potential response from the seller;
  • including non-monetary performance measures such as Strategic Performance Measures (SPMs), potentially reflecting enterprise performance and enterprise behaviour  aligning buyer and seller outcomes and behaviours (see When is a KPI not a KPI? for SPM description).
  • monitoring of the performance and behaviours of the seller to watch whether unintended outcomes are occurring, their response as part of  the routine contract management activities.

However, “testing” it isn’t solely the buyer’s responsibility.  I believe sellers have a reciprocal responsibility to make sure, regardless of whether the PMF of the arrangement allows it, to behave fairly.  For example, during both the tendering process and operation of the contract, I believe sellers should have the courage to tell the buyer of any issues they find in the arrangement, especially one that may lead to a perverse incentive.  Equally, buyers should reward constructive feedback from sellers.

For example, in building the first transcontinental railroad in the 1860s, the United States Congress agreed to pay the builders per mile of track laid; a form of ‘time and materials’ basis of payment.  As a result, Thomas C. Durant of Union Pacific Railroad lengthened part of the route forming a bow shape unnecessarily adding miles of track to maximise payment.  In this case, perhaps both buyer and seller needed another performance measure rewarding the most direct route and speed of construction.

While many will argue that this perverse outcome was a result of dishonesty on behalf of the seller, I believe we as PBC practitioners should acknowledge the potential for perverse incentives in our arrangements and take action to remove, minimise or mitigate putting buyers and sellers in this position.

But regardless of the approach, we all need to be aware of perverse incentives to make sure we don’t end up in our very own cobra effect.

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Perverse Incentives – Part 1

“Common sense is not so common.”

Voltaire

In a previous article (see Designing Successful Performance Based Contracts) I highlighted three tests for a highly successful Performance Based Contract (PBC).  These were:

  1. Does the PBC drives the right behaviour in the seller?
  2. Does the PBC provide adequate commercial protections for the buyer?
  3. Does PBC have a usable Commercial Construct?

While you may believe these three tests are basic common sense, unfortunately there are many examples where, despite the best intentions of the drafters, that these arrangements resulted in an unexpected outcome due to perverse incentives.  So what is a perverse incentive?

A perverse incentive is any incentive, both positive or negative, that has an unintended and undesirable result which is contrary to the interests of the buyer.  In the case of PBC, we are specifically looking at whether our contract “drives the right behaviour in the seller”; that is, does the PBC drive the seller to deliver the outcomes desired by the buyer?

There are many examples where this wasn’t the case including my earlier article (see Unintended and Perverse Outcomes).  For example, I recently saw an article which described the commercial arrangements for transporting convicts from England to Australia in the late 18th and 19th centuries.  While this article has been around for over 15 years it is an excellent read on how a simple change in the commercial arrangements can result in extreme, and in this case, dire consequences.  But there are other, less extreme, examples such as:

  • Dinosaur Bones – 19th century palaeontologists travelling to China used to pay locals for each fragment of dinosaur bone that they delivered. However, given locals were paid on the number of bones they delivered, as opposed to the size or completeness of the overall skeleton, the palaeontologists later discovered the locals would break up large bones or complete skeletons into tiny pieces to maximise their payment, but in doing so, greatly reducing their scientific value.
  • Rat Reduction – in Hanoi, Vietnam, under French colonial rule, the colonial administration created a bounty program that paid a reward for each rat killed based on each severed rat tail produced.  However, Colonial officials began noticing rats in Hanoi with no tails.  Instead of killing the rats, the local rat catchers would capture rats, chop off their tails, and then release them back into the sewers so that they could procreate and produce more rats, thereby increasing the rat catchers’ revenue.  On noticing this perverse incentive, the Colonial officials ceased the bounty.

While all of you reading this will agree all these examples are deplorable, and in the case of transporting convicts, that is trading life for money, criminal, PBC practitioners must be aware of the potential for perverse incentives in our arrangements and that we take precautions to make sure that they are not accidentally included. So how do we do this?  In the next article we’ll look at how PBC practitioners, both buyers and sellers, can avoid perverse incentives.

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Happy 2018 Holidays to all the Performance Based Contracting (PBC) Blog Readers

2018 has been a remarkable year for Performance Based Contracting.

During the past 12 months I have seen PBCs becoming more conventional and mainstream with many discussions within our contract and commercial communities.  Everything from the usual Defence and aerospace equipment contracts, but now extending into areas such as health, consulting and ICT as part of “as-a-service” arrangements.  In 2019, I believe PBCs will become even more common as both buyers and sellers try to maximise the value created by their commercial arrangements; hopefully collaboratively in a win-win scenario!

As for me, I am pleased (and more so my family!) to have finally finished my PBC Book (Mastering Performance Based Contracts).  It was a significant effort to put this together over the past 2+ years in what I hope will help both experienced practitioners and those new to the topic.  In 2019, I can again concentrate on providing regular updates to this blog by providing more detailed discussions and case studies. Furthermore, starting in 2019, together with some friends of mine (Jim Bergmann, Dr John Davies, Michael Frith and Greg Laxton), we’ll together be starting a new blog focused on Collaborative Contracting.

Finally, I hope each of you have an opportunity to have a break.  At this joyous time of year, we are grateful for the time we can spend with our own friends and family, and I wish you all abundance, happiness, and peace in a New Year filled with hope. Happy holidays!

Warm Regards

Andrew Jacopino

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Mastering Performance Based Contracts Now Available in Australia!

After checking this morning I am very excited to say that my book, Mastering Performance Based Contracts, is finally available for Australian readers via www.Amazon.com.au.  My apologies for the delay.

For other countries, Mastering Performance Based Contracts is still available now either through the main US portal, www.amazon.com, or local version of Amazon such as www.amazon.co.uk, www.amazon.fr or www.amazon.de.

I hope you enjoy it and welcome any and all feedback.

Kind Regards
Dr Andrew “Jacko” Jacopino

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