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Performance-Based Contracts: Making the Shift from Products to Services

“People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!”

Theodore Levitt

Today is the golden age of services. The economies of most developed and many developing countries are becoming predominately service based. According to the World Bank services generate about 45% of Chinese GDP, 50% of Indian GDP and 78% of US GDP.

The migration to a service-based economy is leading to a fundamental shift in manufacturing industries toward a business model in which the service component of products, based on the value they provide to customers, is becoming dominant. For a long time high-quality products and innovative technologies sufficed to assure competitive advantages for industrial goods manufactures. However, in today’s global and saturated markets it is getting much more difficult to differentiate a product from competitors’ solutions. The ongoing trend toward commoditization is eroding the value propositions of product-based companies faster than ever before.

As the result, an increasing number of companies are moving from only manufacturing products to offering services associated with the use of their products. For example, Xerox has been very successful in establishing a service business. Company created Managed Print Services many years ago in which it manages fleets of printers and multi-function devices, even those made by other companies, for enterprise clients. Xerox provides maintenance, upgrades, paper and toner replenishment. Clients only pay for pages printed, for a simpler experience and lower operating cost.

The extension of industrial core business by services offers manufactures an opportunity to differentiate themselves from their competitors and also increase their revenues and profitability. A benchmarking study of 50 manufacturers of industrial machinery, conducted by The Boston Consulting Group in 2012, confirmed the attractiveness of establishing a service business. According to this study, on average, services accounted for 30 percent of companies’ revenues—and contributed up to 50 percent of total operating profits at a profit margin of 24 percent. Besides, for the service champions in this sample, the service business contributed an average of 47 percent of revenues and had profit margins of 36 percent.

Corresponding to shifting requirements at the manufacturer’s side, it can be observed that customers are becoming less interested in buying products. In fact they expect comprehensive solutions for their problems and more infrequently draw a distinction between product and service elements. Customers of mission-critical products, such as mining machines, power systems, water-treatment equipment or production lines recognize that the acquisition of new innovative products is not enough, but rather it is necessary to find services that will directly support their businesses. This strict service orientation leads to a new logic that puts the utility provided by the product into the centre of the buying process.

Following this shift towards an extensive service orientation, manufacturers need to up the ante by offering their customers more sophisticated solutions that will support customers’ operations and profitability. The concept of performance-based contracting strictly refers to this point. This approach means that products are no longer sold to the customer but instead the supplier provides and operates them and the customer only has to pay for performance. Within performance contracting the customer does no longer buy products and several services separately, e.g. maintenance or repair services, instead he acquires a comprehensive service bundle. The supplier does not sell the product and instead provides the usage for a fee.

”In the scenario of performance-based contracting, the customer does not buy a product, but instead pays for its utility.”

In comparison to other service offerings the concept of performance-based contracting is characterized by an exceedingly high degree of service orientation and opens up an attractive revenue potential for suppliers. On the other hand, performance-based contracts allows customers to purchase functionality rather than products: customers can buy climate control services instead of heaters and air conditioners, purified water instead of wastewater systems, or to use future energy savings to pay for up-front costs of energy-saving projects. In other words, considering the famous quote of Theodore Levitt: ‘’People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!”, performance-based contracts give customers the possibility to pay only for holes in walls, when buying a drill.

Benefits of performance-based contracts

Performance-based contracts offer a number of potential advantages over conventional service contracts, both for service providers and customers.

Benefits for the service provider:

  • Sustainable competitive advantage. In order to deliver the appropriate outcomes the service provider needs to be able to manage the process that involves co-creation and co-production with the customer. As a result, managing customers to enable better co-creation and co-production effectively becomes a service capability in its own right. Service providers that become adept at customer management in this way can develop a unique competitive advantage providing more opportunities to win new contracts.
  • Lower servicing costs. Performance-based contracts involve a closer relationship between the service provider and customers. As a result, the service provider is more able to optimize and control outcome delivery together with the customer. Greater control over service delivery provides flexibility in reducing the cost of performance while still achieving acceptable outcomes; it allows capacity sharing across multiple contracts providing improved resource utilization and therefore cost efficiencies.
  • Opportunity for innovation. Service providers can use their first-hand experience of working alongside the customer to drive innovation that meets the customer’s changing requirements. The access to the customer’s business or production processes may drive not only the development of new products but also continuous improvement of supplied products and related services. Moreover, new processes required to deliver performance-based contracts may also prompt internal innovations such as the empowerment of cross functional service teams spanning multiple organizations.
  • Improved customer acquisition for highly innovative technologies. In view of the cutting edge technologies, the customers not only lack the appropriate knowledge to maintain – or even operate – but may also be uncertain about the actual benefits inherent in the offered innovations. The more uncertain the customers are about the actual benefits of highly innovative machinery or equipment, the more they will favour a performance based payment to the provider. Performance based contract constitutes a credible signal that the promised benefits will actually be realized and lessens the customer’s uncertainty regarding potentially negative consequences.
  • Improved customer loyalty. Performance based contracts incentivise the supplier to maximise performance, effectiveness and efficiency of his service. This circumstance ensures an environment for continuous improvements, which may also benefit the customer. It forms the basis for satisfying the customer and enables the performance provider to profit from improved customer loyalty and long-term revenues.

”Performance-based contracts help manufacturers develop a unique competitive advantage, providing more opportunities to win new customers.”

Benefits for the customer:

  • Increased motivation of the supplier to provide high quality outcomes. If payment of the service provider is dependent on delivering measurable outcomes, there is greater motivation for him to perform high quality work. Furthermore, purchasing the machinery or equipment’s performance, the customer may get access to qualified operation personnel whose superior knowledge can be exploited.
  • Cost Savings. In the case of conventionally purchasing machinery or equipment, the customer has to bear fixed costs, such as maintenance costs even if the machinery or equipment is not performing, and hence not revealing returns. By purchasing performance, in contrast, the customer turns fixed costs into variable cost that can be calculated with a pre-determined service fee.
  • Predictable costs. By only paying for a measurable specified outcome which is predictable, customers are able to make more accurate cost projections. A good example is a type of performance based contract called ‘Power by the Hour’ – one of the oldest performance based business models developed by Rolls-Royce. Rolls Royce has transformed its support and maintenance contracting model for engines used in commercial jets. Instead of charging customers for repairs, maintenance and spare parts provision, customers paid a fee per hour based on the number of hours of flying time for an engine, thus aligning the cost of engine servicing to the customer’s operational and revenue generating activities.
  • Reduced investment costs. As the customer may offset the gradually incurring service fees for purchasing performance by own revenues, he has more funds available to acquire more advanced machinery or equipment, which might otherwise be financially unfeasible. Moreover, the shift of responsibility for financing and the balancing of accounts to the performance provider is always in the interest of the customer. In this case, the customer may not only protect his own financial resources but can also reduce his capital tie-up in machinery or equipment. The customer, thus, unburdens his balance sheet of the respective assets and does not decrease his capital-asset ratio or increase his equity gearing.

Implementing performance-based contracts

Despite numerous advantages of performance-based contracts, this business model is still not standard practice. There are a number of challenges that service providers may face when implementing a performance based strategy. In order to handle these challenges and develop a state-of-the-art performance-based contracts, managers can consider the following guiding principles:

  • Appropriateness of performance-based contracts. Despite the benefits of performance-based contracting, not every product is appropriate for commercialization under this model. That’s why, managers must be able to assess to what extent the concept can be translated into their business. Within this context the question has to be answered, under which circumstances products, provided by performance contracting are valuable for customers. In order to create additional value to the customer through performance-based contracting, the product has to meet at least three criteria, which are:
    • Derived value for the customer;
    • High life-cycle costs;
    • High technical complexity.

First of all, in order to be appropriate for performance-based contracting, products should create a derived value for customers. In this case value is not created by the product itself but by its utilization. For example, a vehicle fulfils mobility needs only when it is driven. In addition to its functional value a vehicle can also create original value. For example, a luxury car generates a prestige value only by acquiring it. So, in order to be appropriate for performance-based contracting, the product must bring such value to the customer that can be derived from its use.

Product life cycle costs and total costs of ownership is another relevant indicator for the appropriateness of performance contracting. Costs that arise during the life cycle of the product can be devised into costs that depend on utilization and those that don’t. For example, acquisition costs, insurances and taxes don’t depend on the product’s use. These costs arise no matter if the product is in use or not. In contrast to that, costs related to utilization increase with the degree of product use. Among these costs are expenses for maintenance, repairs, personnel expenditures, costs for consumable material and administrative costs. So, a product with a large share of utilization-related costs is more appropriate for performance based contracting. A large share of utilization-related costs enables suppliers to exploit the potential for added value services, and also provides various opportunities for service optimization.

The third criterion is high technological complexity, which stimulates the importance of performance-based contracts and allows their implementation for numerous services. Indeed, operating and maintenance of complex machinery and equipment require a high level of specialized technological knowledge. As the result, customers increasingly request services that directly support utilization of such complex products.

  • Capacity in service delivery. To deliver excellent service and be economically viable, service providers need to have a clear understanding of their capacity and capability to deliver this particular service, and be able to visualize the entire service system. Generally, manufacturers are accustomed to stable and controllable production processes. But when they move into value-added services, they may find front-office service customization turning into a delivery-costs nightmare. Unless they can prevent this, their service margins will suffer. That’s why before going into performance-based contracting, companies should develop a distinctive service supply chain that delivers service products to customers through a network of resources: materials (parts), people (engineers call centre staff, depot and warehouse staff, and transportation staff), and infrastructure (for materials movement and storage, repair, transportation, information systems, and communications).
  • Measurable performance indicators. It is very important both for service providers and customers to agree on what is a successful outcome of the contract and understand how to measure performance. Both the level of required outcome and the related key metrics need to be considered and clearly set out. At its simplest, the contracted outcomes and performance metrics should be objective, measurable, clear and realistic. This is fundamental in a performance-based contract. If you can’t manage performance, you can’t properly remunerate on the basis of performance.

Thus, the typical starting point for developing a performance-based contract is to identify what are the basis for the customer benefits, and from that point define the outcomes that could be measured and serve as an appropriate proxy for those benefits. Take for example a performance-based contract for a highway maintenance. In this case, performance indicators would typically include:

-Specific metrics for the roughness of pavements, rutting of roads                        (e.g. no ruts > 15mm), surface texture and surface skid resistance, number of potholes (e.g. < 10 potholes with a diameter > 100mm on any continuous 5km stretch of road);

-Specific intervals at which these features are measured (e.g. annually) or response times;

-Specific sections of the road network to which the standards apply.

  • Pricing and payment model. One of the fundamental underlying features of performance-based contracts is the direct relationship between performance and the payment of fees. Fees are not calculated on the basis of a transactional pricing model, but are tied to achievement of the agreed outcomes. This is the point at which performance-based contracts have the most potential to be a ‘win-win’ scenario – the better the performance delivered to the customer, the more the service provider has to gain financially.

There are a number of ways in which the pricing model can be structured, each designed to drive quality performance and efficiency. Pricing options include a combination of positive and negative incentives, a gain-share model, contingency arrangements and cost-plus mechanisms. Some contracts can comprise a fixed fee or lump sums, with one or more additional mechanisms under which the service provider can earn increased fees by exceeding expectations.

There are two commonly used payment models for performance-based contracts. First, a performance-based agreement could be contracted on a fixed payment basis tied to performance measures (KPIs) of the identifiable outcome, with pain and gain sharing mechanisms in place. If the performance in achieving the outcome falls short, the prime service provider would have payments withheld or reduced, but with the possibility to rectify and achieve the performance level within a given time frame. On the other hand, rewards for gains could be shared with the customer. Secondly, a performance-based agreement could be contracted on usage, such as Rolls Royce’s ‘Power by the Hour’ contracting where the maintenance of an engine is charged based on each hour the engine is in the air, or as with pay-as-you-go telecommunication charges.

All performance-based contracts must include mechanisms that reward the service provider for reducing the cost of performance delivery (or enhancing performance), as well as imposing penalties for failure to deliver. Various mechanisms for failures and rewards such as payment retention, and weighting performance payments across KPIs, could be put in place. Performance-based contracts should also include stipulations of customer obligations (assets, people etc.), usually termed CFX (customer furnished X) to ensure the service provider is able to deliver on the outcomes. The measurement of KPIs and CFXs should be automated without any manual interventions to prevent potential opportunistic behaviour from either side.

  • Cultural shift. One of the biggest hurdles that many companies face in moving to a performance-based model, more than the commercial, operational and legal issues and challenges that it entails, is the cultural shift in organizational thinking. Shifting to a performance-based business model requires service providers to adopt new skills sets, change attitudes towards the supplier-customer relationship, and acquire a better understanding of how to maximize the advantages of performance-based services.

After all, delivering performance means that everyone in the organization has to work hard at aligning with the customer’s needs. However, in doing so the true meaning of customer orientation becomes apparent and the benefits associated with it. For example, engineers are now asked to exhibit people management skills and behaviours that encourage cooperation and delivering the benefits to the customer, rather than being only focused on the specific technical set of activities.

Usually industrial companies do not sufficiently emphasize the role of people in delivering value (service behaviours and service skills or embedded human capability). There is a high dependency on processes and activities that are equipment focused, without much attention on the behaviours required to deliver value. However, in performance-based contracting, service delivery has a high human component. This indicates that the capacity and capability of human resources are paramount in service delivery and a lack of focus on human resources may result in lower or inconsistent service quality.

  • Financing performance-based contracts. Concerning the capital costs related to retaining the ownership of the machinery or equipment, the performance provider faces the challenge of making own financial resources available for investment in supplied machinery or equipment that can be refinanced only gradually by the service fee. The manufacturers often lack the financial power to stem the increased needs for the investment with sole responsibility and, thus, need cooperating partners, such as banks, even if this causes additional costs.

From a banks’ perspective, the external financing of a performance-based contract will be normally structured as project financing. This financial concept could be defined as: A financing of a particular economic unit (the project) in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan (Nevitt and Fabozzi, 2000).

The functionality of such a project and financing concept is primarily determined by the recoverability of the individual contractual obligations, as well as the corresponding financial obligations. In this respect a minimum grade of creditworthiness for the involved contractual parties will be a prerequisite for a positive credit granting decision. If the creditworthiness of a party is not acceptable to the lenders, a standby letter of credit or a guarantee provided by a creditworthy third party can be an alternative way of enhancing the corresponding contractual obligation.

Alternatively, a performance-based contract can be fully financed by a 100% equity injection in the form of share capital and/or subordinated sponsors loans. Moreover, performance providers may apply more complex approaches of financial engineering, such as the special purpose vehicle model or the operating lease model regarding off-balance sheet financing in order to prevent the burden of ownership of the machinery or equipment and to exploit corresponding capital costs savings.

  • Risk Management. Performance-based contracts are closely related to outcome uncertainty, resulting from a lack of influence on the customer and external economic conditions. Indeed, the service provider has only very limited influence on whether the customer’s product achieves the expected market success or whether the customer changes his manufacturing plan in general. However, a change in customer demand directly affects the capacity utilization of the supplied machinery or equipment.

This uncertainty may even increase further as when defining the machinery or equipment to best fit the customer’s requirements, the performance provider is dependent on the customer’s predictions regarding the expected outcome volume. By exploiting this information advantage, the customer may tend to opportunistically predict higher volumes than are realistic to reduce the service fee. As a result of this volume uncertainty, the performance provider has to deal with uncertain revenues due to the recurrent fixed costs of the machinery or equipment and personnel.

Beyond this outcome uncertainty, the customer may also not fulfil the expectation to act in good faith by opportunistically exploiting the information advantage regarding his machinery or equipment operation behaviour. As for the utilization intensity which directly affects the performance provider’s maintenance costs, only the customer knows his characteristic tendency to operate the machinery or equipment either intensively or carefully.

This issue continues even after the contract has been signed as a moral hazard problem when the customer neither operates his own machinery or equipment nor bears the maintenance costs and, thus, has low-powered incentives to properly care for the machinery or equipment. At the same time, the performance provider cannot observe the customer’s opportunistic behavior due to his comparative lack of proximity to the machinery or equipment and cannot impose disciplinary actions to induce the customer to act in good faith while utilizing this machinery or equipment. Consequently, the performance provider has to deal with uncertain maintenance costs resulting in an uncertain profit.

In order to deal with different uncertainties potentially reducing their profit, the service providers have to search for mitigation strategies that may protect their revenues. For example, if the manufacturer aims to provide the machinery or equipment’s output, he can negotiate minimum service volumes or offer a discount on the service fee if the expected volume is actually achieved. In view of the customer’s opportunistic behaviour the performance provider might tend to set the service fee above his expected average overall costs to compensate for the uncertain maintenance costs. Alternatively, the manufacturer might mitigate potential overuse by monitoring the usage of the machinery or equipment, or negotiate maximum equipment usage and extra charges if the customer uses the machinery or equipment more than agreed upon.

  • Specialized sales-force. As long as a company considers services to be an add-on to existing products, its sales force—with some training—will probably be able to handle both product and service sales. But if companies are moving away from straightforward product-related services into more complex performance-based solutions, managers must take a new look at sales management strategies. Performance-based services require longer sales cycles, and the sales process is often more complex and strategic, meaning that decisions are made high up in the customer’s hierarchy.

Switching to performance-based offerings involves educating sales-force about how their customers’ managers justify decisions internally, so that the salespeople could help the managers they deal with take more responsibility for shaping decisions. Many successful companies made some kind of distinction between product and service salespeople. At GE Medical Services, for example, product salespeople are “hunters,” expected to go out and get orders for new equipment. Service salespeople are called “farmers”; GE expects them to grow their relationships with customers and sell services over time.

Finally, selling performance-based services requires that companies develop the tools to document and communicate the value those services create for customers. These tools range from customer case studies and white papers to sophisticated simulation software.

How the Internet of things is driving the future of performance-based contracts

The latest technological advancements in intelligent hardware and connectivity, otherwise known as the Internet of things, are significantly expanding the opportunities for new performance-based solutions. The manufactures now have a means to create smart and connected products that enable an entirely new range of services, features and capabilities.

Take, for example, John Deere, a traditional manufacturer of large scale and complex agricultural equipment, such as combine harvesters. In 2007 John Deere introduced iGuide technology. By installing a GPS system on its combine harvesters, John Deere was able to provide a new service to its customers. Using GPS technology the firms now tracks the position of ploughing implements in fields. In the past farmers used to create a 10 per cent overlap between furrows to ensure that they ploughed the entire field. Now, with the GPS tracking system, they can increase the productivity of the ploughing process because there is no longer a need to leave the overlap. Also, by integrating GPS tracking on a combine harvester, John Deere could contract farmers on plough performance basis. Today John Deere is going further. The company is beginning to connect not only farm machinery but irrigation systems and soil and nutrient sources with information on weather, crop prices, and commodity futures to optimize overall farm performance.

With the current development of different kinds of cheap and highly-compact sensors, low-cost connectivity and protocols, cheap computer processing power and data storage, a myriad of products could get new monitoring and analytical capabilities previously reserved only for sophisticated and expansive equipment. These smart connected products raise a new set of possibilities for manufacturers to make the shift from traditional product-oriented philosophy to performance-based business models. Finally, offering connected products and creating outcome-based solutions around them, enables companies to expand opportunities for product differentiation and reinforce their competitive positioning.

 

References

  1. Hypko P, Tilebein M, Gleich R (2010) Benefits and uncertainties of performance-based contracting in manufacturing industries: An agency theory perspective. Journal of Service Management Vol. 21 No. 4, 2010 pp. 460-489
  2. Ng, Irene C. L., Williams, Jason and Neely, Andy (2009) Outcome-based contracting: changing the boundaries of B2B customer relationships: an executive briefing. London, U.K.: Advanced Institute of Management Research. (Advanced Institute of Management (AIM) Research Executive Briefing Series)
  3. Belz C, Wuensche M (2007) Classification of performance contracting solutions: a managerial typology. In: 2nd international conference on business market management, March 25-27, 2007, Delft (NL).
  4. Reinartz, W. J. & Ulaga, W. (2008) “How to sell services more profitably,” Harvard Business Review, 86(5): 91-96

 

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