Chapter 38

Performance-Based Contracting

The pattern

Performance-Based Contracting implies calculating the price of a product by considering the services it renders, rather than its face value. Such services are measured as a precise output quantity for which customers pay the company a specified amount (WHAT?, VALUE?). This amount typically includes all pertinent costs such as operations, maintenance and repair expenses, so that customers can more easily control their costs (WHAT?). It is important to note that the use-intensity of the product is irrelevant to pricing, making it essentially the opposite of Pay Per Use (#35). Moreover, this pattern is mostly in B2B sectors, while Pay Per Use is typically B2C. The manufacturer who distributes the products in question will frequently be strongly integrated into customers’ value creation processes (HOW?), passing on past experience of the product and building up new expertise with its use (VALUE?). Integrated own-and-operate systems are an extreme variant of this pattern, whereby a company retains ownership of and operates the product another company has bought (HOW?). The greater financial and operational risk is offset by long-term and more cooperative relationships with customers (VALUE?).

The origins

Performance-Based Contracting derives from public sector infrastructure policies, which have been applying the concept in public–private partnerships (PPP) since the mid-20th century. PPPs are cooperative agreements between public authorities and private enterprises. The public authorities grant concessions to companies, legally authorising them to perform public functions. As a rule, companies are remunerated based on demand fulfilment (for example, the number of available kindergarten places they have created); in other words, payment depends on results.

Over time, results-based compensation found its way to industry. British aircraft engine manufacturer Rolls-Royce was a Performance-Based Contracting pioneer. In the early 1980s the company achieved large-scale success with its power-by-the-hour scheme. Rolls-Royce does not sell engines per se, but rather their performance per flying hour. The engines are owned, maintained and repaired by Rolls-Royce. The power-by-the-hour programme is very popular with customers, and Rolls-Royce generates over 70 per cent of its revenues through it.

Performance-Based Contracting: Rolls-Royce turbines

The innovators

Performance-Based Contracting has been applied in a variety of areas. In the chemical industry, BASF Coatings has been using it since the late 1990s for ‘cost per unit’ models. The cost of vehicle coatings is calculated per item (or module) coated, rather than by the amount of paint used. BASF has taken on some of the responsibility of finishing cars by lending its support to customers in situ and assisting them in improving their efficiency. Any savings achieved from using the finish more economically are split between customers and companies, resulting in a win–win situation.

Xerox is an American manufacturer of printers, photocopiers and other peripherals, which also offers a wide range of document management services. Printers and photocopiers are distributed to customers but remain the property of Xerox. The company’s vast resources and expertise in maintenance reduces costs and increases efficiency. Xerox supplies and maintains the printers, photocopiers and other devices, while customers pay per page printed. Xerox’s superior experience in this field enables it to operate with lower operating costs and increased profit.

In its lighting division, Philips meets the needs of its customers in an innovative way based on the Performance-Based Contracting pattern. All activities, resources and processes required by the customer to illuminate the rooms are taken over by Philips. Philips targets corporate customers who value sustainable building management but are reluctant to build up the necessary skills and investments. The complex management of lamps, maintenance, repair and control is subsequently outsourced to Philips. The customer receives a guarantee for illuminated facilities. For Philips, the financing is provided by the increased energy efficiency achieved with the Philips technology. Philips estimates the traditional electricity costs for the solution, but in the long run Philips will incur lower costs. Another added value for Philips is that the revenue is more predictable.

When and how to apply Performance-Based Contracting

This pattern allows you to monetise existing knowledge and services, including process knowledge, maintenance know-how and related services. Performance-Based Contracting works well if you deal with complex products that also have a challenging application. Customers who want to avoid upfront costs will be inclined to favour Performance-Based Contracting, as will those who desire increased transparency and stability regarding costs of final products and services.