Outcome Based Contracting
Outcome based contracting can be a rewarding venture, especially for those who need specialized work done. Traditional methods of outsourcing tasks can actually reward inefficiency; think of the construction workers standing by the roadside leaning on their shovels or hiring a home improvement specialist for a remodel who disappears for hours on end to the store. These contractors are typically paid by the hour, so there’s really little motivation for them to perform and this is exactly why they can lean on their shovels or spend an extra week doing the remodel. They get paid to procrastinate. With outcome based contracting, the reward is in a job well done, not in making the job last as long as possible.
What is Outcome Based Contracting?
Outcome Based Contracting Definition: With outcome based contracting, an agreement is made that a supplier or provider of services must achieve specific goals and is paid only when those objectives are met.
It’s like hiring the home improvement specialist and telling him that a wall must be built and giving him specifications. How he spends his time and meets those specifications is up to him, and the homeowner doesn’t pay extra if it takes him an additional week. In fact, the homeowner could include a penalty in the contract if the specialist doesn’t have the wall done within an allotted timeframe. An established example of outcome based contracting is “Power-by-the-Hour” by Rolls Royce, which emerged in the 1960s. The program offered comprehensive Viper engine maintenance and replacement based on the number of flight hours. From this point on, Viper owners could know their maintenance fees in advance, budget for them, and have no surprises. Nowadays, outcome based contracting is big in pharmaceuticals and emerging in other sectors like information technology.
- The agreement focuses on a desired outcome, not the steps to get there.
- The outcome is measured using quantifiable data.
- The rate of the reward and consequences are determined by the achievement of specific goals.
Benefits of Outcome Based Contracting
- Reduced costs
- Improved outcomes for customers
- Greater innovation from the provider
- Better responsiveness to the customer’s needs
- Stronger alignment of goals/ partnership between the provider and customer
- Greater motivation for the provider to excel, as the outcome is tied to the reward
- More flexibility for the provider to do what suits the situation best
- Greater efficiency, from start to finish
Outcome Based Contracting Best Practices
Desired outcomes must be clearly identified. Sometimes these types of contracts are called KPI-based contracts because they rely on meeting key performance indicators. The more specific the objectives are, the greater the perceived success of the venture will be.
A plan to measure success must be in place. For example, if the goal is to reduce the cost of power for a datacenter by 10%, it would be easy to check it against bills or to have a power usage monitor installed. At the same time, the baseline must be established as well. Perhaps the month before beginning work had unusually high power use. In this case, it might be better to use an average over a set period of time as a baseline. A second concern is determining when the rate of success will be measured. Will the the success of the project be checked the month after the project is complete or will this need to be done in averages over a period of time too?
Ongoing projects should have exit options. Some agreements involve lengthy or ongoing work. Agreements can be made to reward service providers for the duration of a contract and even afterward. For example, if a provider’s job is to increase sales and the provider does, when do his rewards stop? If his task was a one-time job, should he keep getting a payment each time the monthly sales goals are met as a result of his work? This is a plausible scenario if the provider is a web designer who promises a minimum number of monthly sales from a site he designed. Situations like this need to have hard end dates or exit options for both parties.
Transparency from both parties is essential. Because the service provider is trusting the business to pay at the end based on performance, he deserves to have access to the data that’s determining his payment. Equally, the business may be entrusting the provider with its reputation, security, and profitability. The business needs to know what steps the provider is taking to ensure no shortcuts are used that could affect legality, safety, or ethical standards.
Pricing models should be clear and beneficial to both parties. In many situations, these agreements are done through a process of bidding and negotiation. The business sets the goals and general budget and the contract goes to the provider with the best skills, plans, and experience, but this isn’t the end. Pricing is not always firm. For example, if the parties agree that the goal is for a website to secure 10,000 sales per month, does the provider get any credit if it only gets 5,000? What if it gets 20,000 sales? Does he get a bonus? Because the agreements can also include consequences for not meeting objectives, these should be included as well. A simple one to consider might be time. This would come into play if the provider made a great site that delivered sales, but delivered it a month late. A reasonable penalty could be assessed for each day or week the release of the site was delayed.
Emphasis must be placed on collaboration. In order for outcome based contracting to work, the service provider must have a firm understanding beyond the goals and KPIs. The two parties need to work together, so that the provider understands why the project is important and how it plays into the company’s vision of success. Only then can he craft the ideal solution to meet the needs of the business.