New research shows that performance-based contracting can lower costs.

The concept behind it — “power by the hour” or performance-based logistics — seems intuitively logical. That is, the price you pay for a product or service goes up as the level of service and up time it offers increases, rather grows as you run into problems. So, rather than pay an IT consultant to come out when your network goes haywire, you pay a fixed fee upfront for your system to remain running and problem-free. As a 2007 paper from Knowledge@Wharton notes, “The idea behind performance-based contracting is quite simple: One buys the results of product use (e.g., value creation), not the parts or repair services required to restore or maintain a product.”

The use of performance-based contracting appears to be growing, particularly in the public sector. As of 2006, government agencies in about 40 countries either had implemented or were exploring the use of performance-based contracting, according to a 2009 report by the Transportation Research Board of the National Academies, Performance-Based Contracting for Maintenance. Within the U.S. and Canada, performance-based contracts are in use within a number of states and provinces, the report adds.

The use of performance-based contracting appears to be less common in the private sector. (Or, if companies are using it, they’re keeping a little quieter about it. )

However, Rolls-Royce has been using performance-based contracting for several decades. The company allowed researchers Morris Cohen, Jose Guajardo, and Serguei Netessine at Wharton, along with Sang-Hyun Kim at Yale University, access to its records. The quartet studied five years of Rolls-Royce maintenance records on 700-some products used by 60 customers. The results of their research will be published in a forthcoming paper, although a summary is available here.

Their work is key, as finding clear evidence of the costs and benefits of performance-based contracting has been difficult. The Transportation Research Board report, for instance, indicates that performance-based maintenance contracting results in better outcomes at lower cost and with more financial predictability. However, the report also notes that some agencies remain skeptical of the savings reported, questioning whether accurate comparisons can be made between performance-based and more traditional types of contracts.

In fact, the researchers studying Rolls-Royce ran into just this type of challenge when trying to make valid comparisons between contracts. That’s because the type of contract customers chose varied with the product. Customers that were going to make heavy use of an aircraft were more likely to choose performance-based contracting. This self-selection bias initially made it appear as though reliability was worse under performance-based contracting.

So, they recrunched the numbers, controlling for customers’ self-selection of contracts. This time, it was apparent that performance-based contracting came out ahead. In fact, they found that the average time between engine overhauls jumped by 790 hours with PBC. Along with cutting maintenance costs, this reduced aircraft down time. This research offers critical information for companies who face “big bills when essential equipment breaks down,” the Wharton paper notes.

Treasurers and CFOs who are negotiating service contracts with vendors want them to include several provisions, according to Wharton: The contracts should motivate suppliers to reduce costs, they should provide for a sharing of the risks between supplier and customer, and they should help achieve the highest performance possible. Performance-based contracting, when properly structured, can offer that. ###