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Consider Performance-Based Contracting Arrangements

In a performance-based contract, the supplier provides the Postal Service with specific benefits, such as cost reductions or revenue generation, and in return, the supplier shares in the value created. A portion of the price of the contract is linked to a series of key performance indicators that the supplier is responsible for meeting and to business benefits achieved by the Postal Service through the fulfillment of the contract. The Postal Service shares risks with suppliers in a performance-based contract and allows them to define the methods of performance, thus differing from traditional contracts.

Performance-based contracting agreements create an incentive for the supplier to control its costs. In some contract types, the Postal Service and supplier have conflicting motivations (e.g., the Postal Service wants to minimize costs, but the supplier is motivated to increase its revenue); however, performance-based contracts align the interests of both parties. Performance-based contracts tend to encourage closer relationships with suppliers. The Purchase/SCM Team specifies the outcome or result it desires and leaves it up to the supplier to decide how to best achieve the desired outcome. This can include what to do, when to do it, how to do it, where to do it, or whether to subcontract out (if restrictions do not exist).

Appropriate Circumstances for Use of Performance-Based Contracts

Performance-based contracts should be implemented for projects with outcomes that can be measured objectively (e.g., grounds maintenance, security, computer maintenance, network operations). Performance-based contracts can be used for any contract, including small-dollar-value contracts, but are generally most appropriate when:

Projects are large, have new technology, or have high risks

Existing contracts can be converted to define as much of the requirements in performance-based terms as possible

Large umbrella contracts are experiencing cost overruns or performance problems

Contract is awarded competitively for task order contracts

Benefits contributed by suppliers can be quantified

Project implementation and production time need to be reduced

Postal Service suppliers that are strategic or key should be considered for performance-based contracting. Performance-based contracting allows for the resolution of payment or other issues more quickly and efficiently because of the nature of the shared-risk relationship. In a performance-based contract, the Postal Service must be committed to supplier support because it may have to address issues outside the contract that limit supplier success on the current project.

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Different Types of Performance-Based Contracts

The contract type selected should motivate suppliers to perform as well as possible. To do this, the Client must specify what it wants and know what the project will do for it. The two most frequently used are fixed-price incentive contracts and cost-plus-incentive-fee contracts.

The two constants are that a portion of supplier payment is based on performance and that the supplier shares some degree of risk on the contract. Possibilities for the structure of a performance-based contract include:

The supplier receives a share of any increased revenue generation in return for risking a share of its profits to pay for overruns

The supplier's profits are contingent on meeting explicit performance measures of the indicators

The supplier is required to make a substantial up-front investment and assume most of the project risk

Additional information on contract types can be found in the Select Contract Type topic of the Develop Sourcing Strategy task of Process Step 2: Evaluate Sources.

Key Elements of Performance-Based Contracts

Client objectives and goals must be clear to ensure the success of the contract. Indicators are specified to monitor performance of the requirements. Requirements should be clearly defined and stated in terms of results required, rather than the method of performing the work. A work breakdown structure (WBS) can be utilized to assign requirements to tasks.

Target performance measures are assigned for each indicator and are the basis to financially reward or sanction suppliers. Incentives should be put in place to motivate the supplier's performance. The performance work statement (PWS) or statement of objectives (SOO) describes the effort in terms of measurable performance standards (outputs). Additional information on PWS and SOO can be found in the Start Request for Proposals (RFP) Development topic of the Prepare Project task of Process Step 2: Evaluate Sources. A quality assurance plan (QAP) determines whether supplier services meet the applicable statements' contract requirements.

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Indicators and Performance Measures

Performance standards establish the performance level required by the Postal Service. Correspondingly, the target measure establishes a maximum allowable error rate or variation from the standard. These measures tie supplier payment to performance. Failure to perform within this target results in a contract price reduction. Examples of standards include quality of work, productivity, and cost-efficiency. The Purchase/SCM Team should ensure that each standard is necessary, carefully chosen, and not unduly burdensome. For example, in a requirement for airline services, the performance standard might be "arrival within 15 minutes of an agreed-upon time." The target performance measure might be 10 percent; the airline can be more than 15 minutes late no more than 10 percent of the time. Indicators and performance measures will be customized based on the nature of the purchase.


Incentives are employed to induce better performance and may be positive, negative, or a combination of both. They are applied selectively to motivate suppliers and to discourage inefficiency. Incentives apply to the most important aspects of the work, rather than each individual task.

Incentives will vary from contract to contract and are subject to discussion during source selection and negotiations. The incentive structure should reflect both value to the Postal Service for the various performance levels and a meaningful incentive to the supplier. Effective performance incentives reward suppliers for outstanding work, but do not penalize them for fully satisfactory (but less-than-outstanding) work.

Quality Assurance Plan (QAP) and Examination

A quality assurance plan (QAP) is a component of the purchase plan and describes the strategy and methods deployed to ensure that the purchase and its deliverables are on track to meet Client expectations. In the case of performance-based contracts, it directly corresponds to the performance standards, and it measures supplier performance. The QAP ensures that the Client receives the quality called for in the contract and pays for only what is received. The QAP should include a surveillance schedule and clearly stated surveillance method(s). Surveillance can range from a one-time inspection of a product or service to periodic in-process inspections of ongoing product or service delivery. Additional discussion can be found in the Execute Quality Assurance Plan topic of the Manage Delivery and Contract Performance task of Process Step 5: Measure and Manage Supply.

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Considerations for Using a Performance-Based Contract

Performance-based contracts require more interaction with suppliers than traditional contracts do. The Contracting Officer works with the supplier to determine the monitoring methods, appropriate incentives, risk sharing, payment options, and methods for reporting performance against metrics. Other considerations that may need to be addressed when using this type of contract:

Increased initial up-front costs (e.g., more time and resources to be allocated by Postal Service and suppliers to set up a contract, possibility of a delay to the start of the project, or converting from a traditional statement of work [SOW] to a PWS or SOO)

Payments need to be tied to concrete milestones and deliverables and not necessarily set dates

Data rights and intellectual property issues should be clearly identified

Method to resolve failures is defined; acceptance criterion and a method to inspect are needed

Quadrant Approach

A quadrant approach classifies Postal Service purchases into four categories, depending on their impact on the Postal Service core competencies (noncore versus core) and complexities (standard versus custom). Depending on the quadrant, performance-based contracts will be structured differently; examples of this are illustrated in Figure 2.10.

Figure 2.10

Quadrant Approach

Figure 2.10 drawing showing four quadrants for figure 2.9

Quadrant I: Custom/Noncore Purchase

Custodial - Performance-based contracts are appropriate. The standards identified are desired quality levels. The supplier's technical proposals identify only the frequency and methods to be employed to meet the quality standard. The result is maximum flexibility for the suppliers.

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Quadrant II: Custom/Core Purchase

Mail Transport Equipment (MTE) - Performance-based contracts are appropriate. The supplier is held to a standard of performance and is empowered to use best commercial practices and management innovation in performance. The contract does not specify how many supervisors, mechanics, or other members are required to be in a crew or on the job for servicing and maintenance of mail transport equipment.

Quadrant III: Standard/Noncore Purchase

Information Technology (IT) - Performance-based contracts have limited appropriateness. When developing a new system, the contract is for delivery of a working solution. Acceptance occurs only when the solution is successful, and payments are provided only when (and if) the solution delivers sufficient benefits to cover costs.

Quadrant IV: Standard/Core Purchase

Transportation - Performance-based contracts are appropriate. For example, a supplier may be held to performance standards of on-time delivery, accuracy, and quality.

Other Topics Considered

Start Request for Proposals (RFP) Development topic, Prepare Project task, Process Step 2: Evaluate Sources

Select Contract Type topic, Develop Sourcing Strategy task, Process Step 2: Evaluate Sources

Execute Quality Assurance Plan topic, Manage Delivery and Contract Performance task, Process Step 5: Measure and Manage Supply

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