Performance Based Contracting (PBC) Blog

In the previous article (see Starting a PBC – Part 1) I looked at the need and benefits of using a transition period when starting a Performance Based Contract (PBC). In this article I will look at key considerations to using a transition period when starting a PBC including examining the effect of the transition period on the PBCs Risk-Reward balance.

During a transition period the performance measures can either be implemented (i.e. turned on):

• all at once; or
• phased in over differing times either individually or as groups (e.g. start all supply support performance measures once all the spares part have been bought and delivered).

Additionally, more complex PBCs can also include:

• specific ‘transitional’ performance measures that only apply during the transition period, or
• setting performance levels at a lower performance level during the transition period recognising the need to balance the buyer’s need to hold the seller accountable for some level of performance (even if lower than the final performance level) and the seller’s need to minimise commercial risk during the implementation.

As part of designing the transition period it is also important to balance risk and reward. If the seller is ‘protected’ against non-performance (i.e. paid 100% of the At-Risk Amount regardless of performance) the commercial risk is different and the buyer may want to vary the commercial rewards during the same period. One option many PBCs now use is to ‘shape’ the profit margin during the transition period to reflect the change in commercial risk. This approach is illustrated in Figure 1. Please note that the values used in Figure 1 are for illustrative purposely only and are not recommendations or represent the values in real PBCs.

Figure 1 – PBC Transition Period and Shaped Profit

Important factors to consider when using a shaped profit margin approach:

• While profit shaping commences with the start of the contract the seller can choose an early exit from the transition period. For example, instead of having a 6 month transition period the seller could choose to only have a 3 month, or indeed no, transition period and access the full profit margin from day 1.
• The variation in profit (fee) must be enough to motivate seller’s acceptance of the additional risk (if any). That is, if the difference is too small or the original base profit margin is too high, there may be insufficient reward for the seller to take on the additional commercial risk and exit the transition period.
• Ensure that variation in shaped profit is linked to other Risk-Reward structures within the contract (e.g. contract extension, stop payment, termination, etc.).
• Consider whether the profit (fee) varies with individual performance measures, groups of performance measures or all performance measures.

In summary, the use of a transition period when starting a PBC is a critical step in establishing the right recording, scoring, reporting and reviewing cycles. However, applying a transition period is not a simple as having 12 months without consequences. Instead, it requires both buyer and seller to understand what outcomes they are seeking in the use of a transition period and to tailor it to specifically meet this need.

One routine question when starting a Performance Based Contract (PBC) is whether to implement all aspects of a PBC on day 1 of the contract. Some people, especially buyers, advocate starting all aspects of the PBC immediately, especially the consequences such as changes to performance payment. Others feel that starting the PBC with a small ‘phase in’ period is preferable. So who is right?

With a couple of exceptions I believe there are benefits from starting a PBC with a small transition period. Benefits include:

• getting buyer and seller staff used to recording, scoring, reporting and reviewing performance (e.g. my observation has been that using this process for the first time will uncover issues no matter how clear everyone (buyer and seller alike) believes the contract is); and
• avoiding initial and unrepresentative performance due to:
  • human error; and / or
  • small sample sizes / small durations.

The only exception to the need for a transition period is where the seller has already been delivering the same product or service and there is only minor change in scope or performance levels. In this situation, there is no need for the seller to have a transition period. Indeed, this may be part of the buyer’s justification for remaining with the seller as opposed to re-competing the contract.

Importantly, a transition period should not be viewed as a research phase for:

• selection of new, either extra or different, or deleting current performance measures regardless of whether Strategic Performance Measures (SPMs), Key Performance Indicators (KPIs) or System Health Indicators (SHIs);
• changing the weighting of the current performance measures; or
• defining or changing the contracted performance levels for any of the performance measures regardless of whether SPMs, KPIs or SHIs.

However, where the product or service is so new there is no established performance baseline, the buyer may include a specific transition period to determine this performance level under actual contracted conditions (i.e. in the hands of the user in the field). This is very rare and the transition period would not extend past 12 months in duration. That said, to protect both parties and to prioritise the relationship at the start of the contract, I would always recommend including a minimum of 1 reporting period transition period regardless.

Typically the transition period will last for the first 1 or 2 reporting periods. For example, if performance is reported by the seller and reviewed by the buyer on a 3 monthly basis (e.g. quarterly), it would be common to include a transition period for the first 2 reporting period (i.e. 6 months). During the transition period the buyer and seller record and report performance as they would normally in the contract, however, there are no or “limited” consequences for both positive (e.g. incentives) and negative (e.g. abatements) variation in performance. This is illustrated in Figure 1.  Please note that the values used in Figure 1 are for illustrative purposely only and are not recommendations or represent the values in real PBCs.

PBC Transition

Figure 1 – Effect of a PBC Transition Period on Payment

The reason I have included “limited” consequences in the above description is that most PBCs will keep limited commercial consequences such as the right to terminate for other circumstances during the transition period . Indeed, it would be rare that during a transition period that a PBC did away with all commercial consequences for either buyer or seller.

In the next article, I will look at key considerations when using a transition period when starting a PBC including examining the effect of the transition period on the PBCs Risk-Reward balance.