Although the new normal is still a work in progress, manufacturers are working on enhancing the way they do business and structure their service agreements by adopting and developing new business models.
Business model innovation is as exciting as it is challenging. Manufacturers are compelled to let go of the break-fix model and other traditional agreement models and experiment with new ways to create value and leverage it by changing their value proposition as well as the underlying operating model. From expanding their offerings to communicating their new added value, such a change involves an intensive process of assessing digital maturity, developing the appropriate pricing strategy for optimal profits, and determining what organizational structure and capabilities can facilitate success.
As manufacturers continue to evolve their strategies and rethink the way they manage their service agreements, they are also creating new opportunities to implement resilient and sustainable business models, such as outcome-based and performance-based contracting.
Research shared during Copperberg’s Pricing Excellence US Summit, hosted on 9 December 2021, revealed that manufacturers and original equipment manufacturers (OEMs) are already preparing to deploy their innovative models in the new year. According to the Magic Quadrant for Field Service Management, in 2022, more than 60% of asset manufacturers will offer outcome-based service contracts, up from less than 15% in 2018.
To better understand why outcome-based and performance-based contracting are increasingly gaining traction, we first need to look at their relevance in today’s business landscape as well as their benefits and the challenges they may present to adopters.
What is outcome-based contracting?
Outcome-based contracting (OBC) is a service business model that focuses on the output, quality, and results of services provided rather than prescribing a required headcount of tasks, maintenance, repairs, or other assets. In other words, OBC is about selling outcomes, not services.
With OBC, the lifecycle of a contract is extended with added value as the service provider commits to helping the customer achieve attainable and measurable results. Service providers offering OBC tend to be more mature digitally and leverage the opportunity OBC creates to adopt cutting-edge technology, optimize processes, and develop innovative solutions to enable their customers to meet their goals. As such, OBC creates win-win situations for both customers and service providers.
Outcome-based contracts are highly customer-centric as they take into account the customer’s barometer for success. Because of this, not all outcome-based agreements are the same and the key performance indicators (KPIs) they oversee are established on a case-by-case basis. In many cases, customers are unsure which KPIs are more valuable and count on the service provider to help them decide. Some of the more common customer KPIs for outcome success are delivery time, cycle time, throughput, overall equipment effectiveness, production downtime versus operating time, net operating profit, and unit contribution margin.
This win-win approach to service agreements generally enables businesses to become more agile and achieve results such as improved efficiency and accuracy. It also enables the provider to have more control over the service delivery process. More control over the service delivery process means increased customer satisfaction. With the provider owning the delivery process, the customer has significantly increased chances of receiving exactly the services they need for their successful outcomes.
What is performance-based contracting?
Performance-based contracting (PBC) and OBC are close cousins. PBC is also an outcome-oriented contracting method but the emphasis falls on service performance rather than service outcomes. Fundamentally, they appear to be the same model, but PBC differs in the application and displays key characteristics such as:
- Requirements that focus on contractual outcomes, not the performance of service;
- Set of indicators pertaining to the outcome agreed upon;
- Achievable performance standards for each indicator;
- Defined processes for the collection, analysis, and reporting of the data for the selected indicator;
- Performance-based monetary and non-monetary consequences such as rewards or sanctions for the provider.
Within a PBC service agreement, different performance levels and their fees are established between the service provider and the customer, including:
- Required performance level—the standard the service provider is expected to deliver consistently for 100% of the cost.
- Minimum performance level—at this level, the customer experiences no value from the service being delivered, eliminating the customer’s obligation to pay the performance fee.
- Inflection performance level—a transition level between the required performance and minimum performance levels, which typically involves an 80% performance fee.
- Incentive performance level—above required performance level or superior performance that delivers added value for which the customer pays more than 100% of the cost.
Although OBC and PBC are often used interchangeably and have fundamental similarities, OBC can be delivered without PBC but not necessarily the other way around. An outcome-based service agreement can be established without prominent considerations regarding performance.
Benefits and potential challenges of OBC and PBC
The adoption of OBC and PBC service agreements has helped many manufacturers and their customers unlock new revenue streams and achieve higher levels of success. But transitioning to such innovative models creates a few unique challenges as well.
1. Differences regarding the outcome
Sometimes, service providers and their customers fail to agree upon the outcome of the agreement due to different levels of digital maturity and a lack of knowledge regarding the customer’s business. Likewise, there are often challenges in identifying the appropriate KPIs for customer success. The decision-making process can be long and daunting, delaying the implementation and execution of service.
2. Change aversion
Even in business, human beings are averse to change, no matter how beneficial it may be. Legacy models are comfortable and familiar, so building a business case for OBC or PBC is essential for both customers and service providers. Additionally, service training and effectively communicating the added value of the supplier owning the service delivery process can help streamline adoption.
3. Pricing difficulties
Predicting outcomes, assessing risk-to-reward ratios, and then setting the right price can be cumbersome and make room for a lot of guesswork. That’s why alignment on customer success metrics is vital. And it’s also vital to have access to relevant data regarding past transactions and service history and performance in order to make informed pricing decisions.
Any business innovations, including adopting new service agreement models, create unique challenges for the manufacturers preparing their infrastructure for transformation. All change comes with risks. In the case of OBC and PBC, the benefits far outweigh the risks and challenges presented above. By transitioning to OBC or PBC, manufacturers can:
- Strengthen customer relationships, improve satisfaction, and nurture loyalty by owning the service delivery process. The likelihood of their customers sticking with them for the long run is directly proportional to the level of effort the provider invests into helping their customers achieve success.
- Extend the contract lifecycle with added value and transform any transaction into a new customer relationship. By selling more than just products and prescriptions, service providers have the opportunity to learn more about their customers and tailor solutions for their specific needs, thus creating value for customers that they might not be able to find elsewhere.
- Scale their XaaS or servitization model and unlock new revenue streams through expanded offerings, customized solutions, innovative use cases, and more. By working in tandem with the customer, service suppliers can identify needs that the customer is not even aware of, thus creating opportunities for new solutions to be developed.
- Save costs while also helping their customers reduce their spending. By owning the service delivery process, the provider is compelled to maximize their investment in digital transformation and leverage the corresponding cost-effective solutions, such as IoT and predictive maintenance. All the while, the customer no longer has to waste resources on unplanned downtime, repeat repairs, and production loss.
Overall, OBC and PBC create great opportunities for scaling servitization and digital transformation. These innovative business models also create competitive advantages for providers, enabling them to differentiate themselves from their peers through know-how that can be delivered for multiple use cases.
Organizations that have already deployed AI-powered and IoT-enabled solutions, can accurately measure and control outcomes. By harnessing the power of data, the realization of the outcome can be thoroughly planned and executed for the customer’s satisfaction.
Furthermore, the outcome realization process involves a degree of pricing flexibility that enables providers to set prices based on the customer’s unique needs. This flexibility and control over pricing is also an opportunity to increase revenue.
Final considerations for transitioning to OBC and PBC
For servitized and digitally mature organizations, OBC and PBC are resilient and sustainable business models that have a great potential to increase profit and productivity for both providers and customers. For new adopters who haven’t consolidated their servitization and digital transformation, certain considerations are recommended before transitioning to OBC or PBC, including:
- Understanding what can be monetized in terms of outcomes. Not all OBC or PBC agreements are the same and they can be structured in a variety of ways, so it’s important to identify the KPIs that make sense to both provider and customer.
- Defining the monetization strategy and how the service will be charged, measured, paid for, and so on.
- Identifying the responsible parties in the realization of the outcome and assessing their capabilities.
- Leveraging the potential of predictive maintenance in service processes to streamline delivery.
- Performing data audits to ensure service accuracy and derive insights relevant for customer success.
Last but not least, perhaps the most important consideration is that embracing outcome-based service is not only different for every organization, but also for every customer. Offering contracts built on a guarantee means developing internal capabilities that can help measure and optimize performance for successful customer outcomes.