Imagine paying for your car only when it works. Or your television. Or even your high-end toaster. That might sound far-fetched, but it could be the future model for purchases requiring service over time.
Known as “Power by the Hour” (PBH) in the private sector, this new approach is already reshaping customer-supplier relationships in defense and aerospace contracting under the name “Performance-based Logistics” (PBL). Customers and suppliers of mission-critical products, such as semi-conductor manufacturing equipment, commercial aircraft and military weapon systems, are recognizing that the acquisition of world-class products is not sufficient, but rather it is necessary to provide superior, cost effective maintenance and support services throughout the after-sales phase of the customer-supplier relationship. A major focus of these efforts involves re-designing the contractual and implicit relationships between customers and suppliers in the service support supply chain.
At the heart of PBL is the notion that risks and incentives should be more equitably aligned between suppliers and customers than has been possible under traditional “fixed-price” or “cost-plus” contracts. According to a recent paper and conference presentation by two Wharton professors of operations and information management, Morris A. Cohen and Serguei Netessine, and doctoral student Sang-Hyun Kim, performance-based contracting may also “improve product availability and reduce the cost of ownership by tying a supplier’s compensation to the output value of the product generated by the customer.”
Without doubt, they argue, this new strategy is fast becoming an important component of the management of after-sales service supply chains, with implications that potentially reach beyond defense and aerospace contracting, and into certain retail sectors. And, if their future analysis of risks and incentives in contracting holds true, they predict that the optimal customer-supplier relationship will be realized by combining performance-based contracting with elements of more traditional service agreements.
“What kind of contract do you want to structure for suppliers?” Netessine asked a recent gathering of aerospace and defense industry representatives at the 2006 Wharton Service Supply Chain Thought Leaders Forum. “First, the contract should give the supplier the incentive to reduce costs. Second, it should share risks. Third, you want to achieve the greatest performance possible. It’s intuitive — the optimal contract is really a combination of three things: fixed payment or fixed price, cost-sharing and performance-based compensation.”
In a recent paper titled, “Performance Contracting in After-Sales Service Supply Chains,” Netessine, Cohen and Kim analyzed performance-based relationships by putting different contracting considerations under the microscope in a principal-agent analytical model. “Performance-based contracting in service supply chains offers a fertile ground for research where economics and classical inventory theory converge naturally,” they write. “Not only does it pose theoretically challenging questions, but also insights gained from the analysis are of great interest to practitioners who are currently undergoing major business process changes due to the move towards PBL contracting.”
The researchers focused on contracts related to support and maintenance services, which they say “constitute a significant part of the U.S. economy.” The study goes beyond the traditional maintenance contracts that are used for relatively simple products like automobiles or electronics, looking instead at contracts for mission-critical products in capital-intensive industries such as aerospace and defense, which include the maintenance and repair of all classes of military and commercial aircraft as well as defense equipment. In the commercial aerospace sector, for instance, PBL has become a standard contract provision for the support of such key sub-systems as aircraft engines and avionics systems.
The economic impact of such service contracts is significant. The authors argue that support and maintenance services can generate “up to seven times as much profit as do sales of original products over the lifetime of product use.” For example, a study by Accenture found that $9 billion in after-sales revenues produced $2 billion in profits for General Motors, which is a much higher rate of profit than its $150 billion in car sales generated over the same time period. According to the same study, after-sales services and parts, which contribute 25% of revenues across all manufacturing companies, “are responsible for 40-50% of profits.”
Unlike extended warranties purchased by consumers for a fixed payment to cover repairs on products like cars or appliances, the Wharton researchers write that the complex systems found in aerospace and defense “require more sophisticated relationships between service buyers and suppliers.” In these industries, it’s “very hard to guarantee product availability due to significant uncertainties in product reliability and usage as well as inherent product complexity, resulting in large risks to both the customer and service provider. Therefore, service support in these industries is typically conducted using fixed-price or cost-plus contracts.”
Fixed-price vs. Cost-plus
With a fixed-price contract, the buyer pays a fixed fee to the supplier to purchase necessary parts and support services. With a cost-plus contract, the supplier repairs the product and charges full cost plus a premium to the buyer. According to the Wharton report, the vast majority of service contracts in the defense industry include cost-plus payments. It is well understood, however, that there are inherent flaws relative to incentives and costs when service is provided under a cost-plus or fixed-price contract agreement. As Netessine pointed out during the recent forum, a fixed-price contract puts all of the risk on the supplier but provides few performance incentives. On the other hand, the cost-plus contract actually shares the risks between customer and supplier, but provides few or no incentives for the supplier to reduce costs. “What is the point for the supplier to repair this product at the lowest possible cost? Everything gets reimbursed,” Netessine said. “I would inflate my cost as much as I can if my profit margin depends on this. There is no incentive to do it in the most cost-conscious way, and that [is] a problem.”
After working with major defense contractors over the past few years, the researchers noticed the start of what is a major shift in service logistics — what Cohen thinks “has the potential to be a major sea change.” At the Department of Defense (DoD), for instance, pure cost-plus and fixed-price contracts are slowly losing ground to the new concept of support contracts for service supply chains with a performance-based component. “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.”
In official U.S. Department of Defense guidelines, the government gives this definition of performance-based logistics: “The essence of Performance Based Logistics is buying performance outcomes, not the individual parts and repair actions…. Instead of buying set levels of spares, repairs, tools, and data, the new focus is on buying a predetermined level of availability to meet the [buyer’s] objectives.”
According to Netessine, “With performance-based contracting or power by the hour, basically you pay for the equipment when it works. And you don’t pay for it when it doesn’t. I’m not paying for the repairs or the spare parts. I am buying a working airplane, and when it works, I pay you. When it doesn’t, I don’t.”
The Rolls-Royce Engine
At the conference, Cohen acknowledged that the concept of performance-based contracting “has been around, and some would argue that the commercial application is ahead of the military.” He pointed out the term “power by the hour” was coined by Rolls-Royce over 20 years ago to describe their performance-based contracts for engines and other avionics products that were sold to commercial airlines. Today, “engine manufacturers General Electric, Pratt & Whitney, and Rolls-Royce all have performance-based contracts with commercial airlines in which their compensation is tied to product availability (hours flown),” the authors write in their study.
In fact, Rolls-Royce carries a registered trademark on its Power By The Hour programs, which are “available on several Rolls-Royce engines,” according to the company. “These programs provide the operator with a fixed engine maintenance cost over an extended period of time. Operators are assured of an accurate cost projection and avoid the costs associated with unscheduled maintenance actions.”
The researchers note that the Department of Defense initiated 57 PBL programs in 2002. The contracts were such a success that on August 16, 2004, the defense department issued a memorandum which “requires program managers to develop and implement PBL strategies that optimize total system availability,” thus mandating that all future support contracts be based on performance. In 2005, the number of PBL programs in the department climbed to 92.
Granted, not every supplier has been thrilled. Cohen, Netessine and Kim add that when the DoD solicited 128 suppliers for bids on a recent PBL support contract, only five responded positively and the rest simply responded “not interested.” According to one major DoD contractor, “After nearly five years since its inception, PBL still is generating a great deal of discussion and will engender a major cultural and responsibility change at the supplier level.” In addition, the Government Accountability Office had questioned the “purported benefits of PBL arrangements,” concluding that “DoD programs offices could not demonstrate that they have achieved cost savings or performance improvements through the use of performance-based logistics arrangements.”
“There has been a lot of outcry — from both sides,” Netessine says. “The Department of Defense figured out that PBL benefits them because they only pay for what is operational. It makes suppliers work hard to make sure the equipment is operational, etc. But suppliers are not so sure they want it. During the conference, [we heard from] suppliers to the Department of Defense, who said, ‘We don’t know what to do! We don’t even know how to charge for this. We know how the old contracts operated and we can estimate our potential profit, but now we have no idea what to charge for performance-based logistics or how to manage our relationships with our suppliers.'”
Controversy and uncertainty with regards to PBL “underscores the urgency and lack of understanding of PBL arrangements,” the authors write in their study. “The academic literature, however, offers little guidance with respect to how such contracts should be executed. In this paper, we aim to take a first step towards filling this void by proposing a model of contractual relationships that arise in practice when procuring repair and maintenance services in a performance-based environment.”
Performance and Risk
For their economic analysis of PBL contracts, the Wharton researchers had access to data on real-life support for a fleet of 156 fighter jets. The study analyzed data on unit costs, daily failure rates and repair lead times for a representative collection of 50 line replaceable units in five sub-system groups: avionics, engines, landing gear, mechanical and weapons. From this preliminary study, the authors focused on two important issues of contracting in service supply chains — performance requirement allocation and risk sharing. They concluded that:
- Risk plays an important role in what contracts work best for individual suppliers. Risk-averse companies are more likely to choose contracts that combine fixed-payment, a cost-sharing incentive and performance incentives than risk-neutral companies, who may prefer performance-based contracting.
- When the client is more risk-averse than the suppliers, the performance incentive increases while the cost-sharing incentive decreases with time. Conversely, if the client is less risk averse than the suppliers, the performance incentive decreases while the cost-sharing incentive increases with time.
- The allocation of performance requirements and contractual terms change during the product life cycle. In short, contracts are likely to evolve and the mix of contracts will change during the life of the program or the product. For instance, Netessine noted that performance incentives should be low when cost uncertainty is high, and high when cost uncertainty is low. “Those two incentives are kind of substitutes,” he said. He also pointed out that cost-sharing is generally stronger when cost uncertainty is high, a condition that exists most often at the beginning of the product life cycle. “During product deployment, you want to do extensive cost-sharing. However, as you move into maturity, you change, you adjust your contract. You give large performance incentives and you provide limited cost-sharing.”
- For different products, clients should have different contracts. “[During the conference], someone mentioned that they tried to put all the different products from one supplier under one PBL agreement,” said Netessine. “According to our model, that might not be the optimal thing to do.”
At a time when governments and officials are grappling with how to structure PBL contracts and how to measure contract performance, the Wharton experts acknowledge that the “very definition of PBL is open to a wide range of interpretations that includes elements such as efficient material management, incentive based contractual relationships, and a transfer of support responsibilities and/or asset ownership to suppliers.” Indeed, they predict, PBL “represents a completely new paradigm for delivery system sustainment which ultimately could encompass all of these components.”
The preliminary evidence and their recent theoretical analysis have convinced Cohen, Netessine and Kim that “PBL should be an integral part of system maintenance and logistics support programs. Performance-based customer-supplier relationships are becoming widely accepted as an important component of a new strategy for the management of after-sales service supply chains.”
Which is why Cohen, Netessine and Kim have taken the next step: They have started an empirical research project to properly define PBL and to determine why and when PBL or power by the hour works. They are working with both customers and suppliers who are familiar with the PBL environment and contract provisions in order to develop a classification of PBL and PBH relationships; to determine the main drivers of performance improvement; to identify incentive effects under PBL and PBH; and to analyze the requirements for a successful PBL and PBH implementation.
“That’s our current focus,” says Netessine, who adds that the study is still accepting participants. “To get empirical data, to see how contracts perform, and hopefully to pass along contract models.”
The Wharton researchers are also working on an economic analysis of the incentives to invest in reliability improvement for products through product re-design and engineering change. The ultimate improvement of product reliability is often included with increased up-time and a lower cost of ownership as predicted benefits of PBL contracting arrangements. Their initial results indicate that inclusion of performance-based payment is linked to investment in reliability improvement and can lead to efficient supply chain performance.
Cohen believes that the takeaways from their studies could eventually impact not only the aerospace industries or military government contractors but individual consumers and retail markets, too. “It raises the question in my mind of why do customers need to own products? When I talk about [PBL], I always ask the question, ‘Why do we acquire products?’ If you are buying a food product that you consume, you have to own it to consume it. But if you talking about an automobile or a television or a hair dryer, do you need to own the product to use it? Not necessarily. Why not contract for use, and pay on the basis of the value of that use? It goes beyond leasing a car — it’s more like a taxi ride, and you pay on the basis of that ride. As we move more and more to a service economy, I may not always have to own.”
Cohen cautions, however, that the creation of this new “performance model realigns the incentives. You pay me because something worked, not because it broke. There is a lot of uncertainty with this model. The point is, many companies make most of their profits from selling support and parts after the sale. The whole focus of incentive economics as applied to supply chains is that when we understand what the incentives are, we will make the decisions that maximize supply chain value. It’s supposed to be a win-win. This [PBL model] has the incentive to do that, to coordinate the supply chain and improve the overall performance of the supply chain. The jury, however, is not in on that.”
Performance Contracting in After-Sales Service Supply Chains
