Understanding Performance-Based Contracting Methods

KEY TAKEAWAYS:

• Performance-based contracts allow suppliers to adapt clauses to fit their specific performance needs.
• Performance-based contracts contain five components typically geared towards payment contingent on set performance goals.
• Suppliers can increase long-term success with properly structured performance-based contracts.

Raise your hand if you love doing the same repetitive contracting task, hour after hour, day after day. If you want to excel as a contracts professional, you must become an expert at drafting, negotiating, and managing complex contract structures.

It may be years before AI is effective enough to replace human beings who can work with complex contracts. But AI will continue to automate repetitive contracting tasks at an ever-increasing speed, which includes drafting and negotiating some of the more standard contracts, like non-disclosure agreements. Human beings using well written, fairly negotiated and well managed performance-based contracts can adapt to changes in the supply chain, while ensuring supplier performance.

What Is a Performance-Based Contract?

Performance-based contracts are a class of agreements where payment for goods and services is contingent on the supplier achieving clearly outlined performance goals or desired outcomes. This is different from paying a supplier for a one-off delivery of a good or service, even if that delivery happens once a month for a definitive period of time.

Typically, performance-based contracts contain the following five critical components:

1. Performance Work Statement (PWS) or Statement of Work (SOW)

Work requirements are details about the goods or services the supplier will deliver. They are typically written before bidders submit a proposal. The work requirements can be written as a Statement of Work or as a technical specification. The supplier must meet all of the work requirements to fully deliver the goods or services.

2. Quality Assurance Surveillance Plan (QASP)

The QASP provides specific details on how the buying company will survey, observe, test, sample, evaluate, and document contractor performance results to determine if the supplier has met the required standards for each objective in the SOW or technical specification.

3. Performance-Based Metrics

Performance measures should ensure that the supplier performed the work according the to the requirements, be reasonable, and achievable.

4. Contractual Incentives or Disincentives

Incentives are things like a bonus for exceptional performance or Liquidated Damages or Service Level Credits for poor performance.

5. The Right Pricing Model

A pricing model is the mechanism for pricing the work, such as a lump sum or a direct cost pass through. The pricing model can either drive or hinder supplier performance.

For example, a utility company could enter into a performance-based contract for the purchase of maintenance services for a turbine. The utility company would establish a technically specific scope of work with specific performance metrics. The work would be performed and inspected according to a quality assurance plan or manual. The utility may include Liquidated Damages for a lack of schedule adherence to complete maintenance on time. Finally, the utility may also choose a direct cost payment for labor hours including a fixed percentage for mark-up and overhead. This pricing model will allow greater cost transparency and control over the mark-up and profit on services that are repeatedly performed.  

By contrast, the purchase of the parts that will be used to perform the maintenance may not be a performance-based contract unless the purchase meets all five components listed above. Typically, the purchase of parts, even if the parts are delivered regularly, do not require all five elements of performance-based contracts.

This is a whole lot easier said than done. Performance-based contracts can be competitively awarded or sole sourced.

Are You Working with Performance-Based Contracts?

Look at the contracts you draft, negotiate, and manage to identify the five elements noted above. Are all five elements present?

Then ask your company if it is getting value from this agreement. If not, something needs to be re-written, re-negotiated or better managed. If one of the elements is missing, and that is not unusual, what can you personally do to insert the missing element at contract renewal or upon a successful award?  

If you are one of the many suppliers realizing this applies to your company, you are in good company. It is never too late to implement these strategies. Every supplier I’ve ever worked with wants to perform, make a profit, deliver value, and continue to support the relationship for years to come. Properly structured and managed performance-based contracts will ensure long-term success for the parties involved.  

Are you intrigued to learn more? Each month right here, I will provide more information to help you draft, negotiate, and manage performance-based contracts through my Contract Nerds guest column, Negotiating Performance-Based Contracts.

If you want the manual to learn at your own pace, purchase your copy of The Contract Professional’s Playbook: The Definitive Guide to Maximizing Value through Mastery of Performance- and Outcome-Based Contracting.