Thinkholdings Blog Making the case for performance-based contracts By Ryan Furnell, Anklesaria Group

As procurement professionals, we know that demonstrating the value delivered through suppliers is difficult. It's even more difficult to measure the return on our supply investments.Performance-based contracts are one way to demonstrate value. However, they always involve more oversight and effort, which is why they tend to make sense only for high-value, complex purchases or instances where the outcome is uncertain. Are they worth the effort?More and more, I'm seeing performance-based incentives in service-related contracts. Some recent projects involved paying for• Maintenance of critical OEM equipment based on fired hours in the oil industry;• IT services based on percentage uptime in the telecommunications industry;• R&D based on a hybrid metric of the capitalization of R&D expenses and product proliferation in the food industry; and• Construction projects based on schedule and risk mitigation metrics in the health industry.Other more common examples include lawyers who charge a percentage of their client's settlement and real estate agents, banks and fund managers who charge a percentage of the transaction or asset base.I love the idea of performance-based contracts, especially when the scope or outcome is uncertain. However, I have two concerns. First, performance contracts are typically suggested by the supplier for a "black-box" situation, meaning the customer entrusts a complex task to a supplier or can't see what the supplier is doing. Second, the supplier's bonus is paid more often than not, while poor performance is explained away by exceptions or out-of-scope items.I propose we open the black box and look inside. We want to understand the service, the process steps and the costs. It's our job to know that our suppliers are acting responsibly on our behalves. However, this means we need the knowledge or mechanisms to understand what's happening "under the hood," at least from a commercial perspective.At the same time, we must respect that the service provided is extremely complex and of high value to our organizations. To that end, a very lucrative upside potential for the supplier is important. If we're going to endorse a performance-based contract, we need to actively manage the contract both technically and commercially and be open to the supplier's involvement in the active management of the arrangement. Active management includes measuring and discussing poor performance and translating those measurements into supplier incentives and performance evaluations for specific individuals on both sides. The evaluation piece is particularly difficult because it requires having candid conversations in a way that preserves the working relationship.The next step for supply professionals is to ingrain active management of performance-based contracts into our companies' cultures. Perhaps we could learn from social psychology where raw and often personal discussions are a means to increase mutual understanding and deepen relationships.http://anklesaria.com/making-the-case-for-performance-based-contracts/