Does Performance-Based Contracting Work for Procurement?

Procurement teams invest a lot of time in choosing the right supplier – one that has a good track record and aligns with their business goals. 

They also make a lot of effort while negotiating contract pricing and payment terms. When awarding a contract to a vendor, they often have specific objectives to achieve. How do they plan to measure the vendor’s performance against these objectives?

Including performance metrics in the vendor contract is a good idea. For example, your procurement team may want the vendor to prioritize your order and deliver components within a month, or you want the vendor to clearly showcase some aspects of sustainability in its goods. 

Does the inclusion of performance metrics appeal to vendors? Does it benefit them in any way? Let’s find out. 

What is a Performance-Based Contract?

Performance-based contracts link vendor payment to the achievement of specific goals or results, rather than the delivery of inputs. A software development company, for example, may award a performance-based contract to a vendor based on the quality of the software, number of features, technical glitches, or user experience. 

The focus, in such a contract, shifts from the number of hours worked or resources used by the vendor to the achievement of specific goals agreed by both parties at the beginning of the contract. 

Both parties refer to a Performance Work Statement (PWS) or Statement of Work (SOW) that outlines specific work requirements as well as outcomes. 

Advantages of Performance-Based Contracting

In a performance-based contract, the vendor clearly knows the goals at the outset. There is greater alignment and little chance of misunderstanding. Also, when vendors prioritize outcomes over simple deliverables, they work toward the same goal as the organization. Done right, performance-based contracting can align the incentives of both the parties. It can encourage vendors to innovate. It can also reduce the chances of poor performance. By creating a win-win situation for both parties, performance-based contracts can foster collaboration and trust between the parties. Both parties communicate regularly to check the progress of defined goals. They can also change their strategy midway in case the performance is not as expected. Thus, these contracts are more flexible, and the vendor can adjust to the changing requirements of the business. 

Drawbacks of Performance-Based Contracting 

Performance-based contracts require the buyer and seller to mutually agree on the definition, measurement, and validation of the outcomes or results. This makes designing and implementing these contracts difficult. Also, as payments are linked to the original outcomes, there is a possibility of conflict between the two parties. 

The vendor may choose to focus on the most profitable outcomes, or those that can be achieved easily. At times, vendors may manipulate the data or evidence to claim the payment. Or vendors may feel pressured due to performance-based payment, and this may restrict their ability to work independently and innovate. 

For effective performance monitoring, these contracts need a Quality Assurance Plan (QAP). Without a well-defined quality plan, businesses may struggle to assess and evaluate vendor performance against the set outcomes. 

Another problem is the focus on short-term wins. Vendors may cut corners to achieve quick wins and ignore sustainable, long-term benefits in the process. 

How to Effectively Use Performance-Based Contracts 

Performance-based contracting can be a helpful tool for contract negotiation, but it requires careful planning, execution and evaluation of the results. 

At the outset, you must define the outcomes clearly. Both parties should agree on these outcomes. Ensure that these outcomes are based on the expectations of the buyer and the capabilities of the seller. Detail the scope of work and quality expectations upfront. Secondly, the performance indicators or metrics should be specific, relevant, and verifiable. Both parties should understand what exactly is needed and by when. To avoid the possibility of a dispute, the payment terms should be fair and transparent. They should clearly outline the incentives and penalties for vendors. 

It is also important for both parties to communicate regularly and check progress constructively. The buyer may identify improvement areas and reiterate the expectations to the vendor. 

Finally, buyers must measure and evaluate the outcomes objectively and comprehensively. Review the outcomes, if needed, and use the results to improve future contracts. To make contracts more flexible, buyers can also define in-built mechanisms to accommodate changes in project design, scope, unforeseen situations, or evolving stakeholder requirements. 

What’s in It for Your Business 

Performance-based contracts may or may not be suitable for your procurement function. This would largely depend on the nature and scope of the project and specific requirements of the contract. 

You should consider performance-based contracting if procurement believes that there is a strong business case to link vendor payment to specific goals.