By Dr. Mike Körner //
“Performance-based contracting” (PBC) is gaining significance in the context of maintenance and spare parts procurement for the main weapon systems of the German Armed Forces. Where flying platforms such as Eurofighter Typhoon and NH90 are concerned, it is the key element to increase material readiness.
In a PBC agreement, industry commits to achieving performance and availability targets which are then followed up by metrics. Industry is, to a large extent, fully responsible for the supply of spare parts or maintenance or logistic services to ensure availability. Depending on achieved availability and performance the incentive share for industry increases or decreases, and with it the profitability of the services provided.
Countries like the US, UK or Australia are actively using PBC agreements for managing supplies of spare and replacement parts of their flying systems since the 1990s. Their positive experience in terms of cost savings and increase in operational readiness has been examined and confirmed for each of the affected programmes. By implementing PBC, cost savings of more than 20% and an increase in operational readiness between 20% and 40% on average could be achieved (source: BAAINBw L6.3., 2017).
But what exactly changes when shifting from traditional service business to performance-based contracting?
Traditional service contracts are based on the input factors “man hours and material”, with framework conditions fixing technical and process execution in detail. The old cost-plus contracts incentivise industry to increase the profitability of services by using more man hours and material. By applying the result-oriented incentive system PBC, this logic is reversed. Profitability can be increased by saving cost and increasing efficiency, i.e. less man hours and less material. To realise these effects, industry is granted a higher degree of freedom in organising and implementing the services.
The monetary incentive mechanism is the key element to ensure alignment of interest between the Armed Forces (system availability) and industry (profitability targets). It is the core of performance-based contracting.
A typical incentive model for a material supply contract works in two steps: in the first step, cost savings compared to a target price determine the level of the incentive amount to be shared in absolute terms. In the second step, the relative distribution between industry and Armed Forces is determined based on the achievement of contractually agreed metrics. The higher the target achievement with regards to the metric (e.g. on-time availability of spare parts), the higher the industry share. For a PBC incentive model, the combined consideration of both “savings” and “achieved performance” is important. If there was, for example, only a savings target in a material supply contract, industry would save on procurement and availability would be adversely impacted. If only availability was measured, industry would be interested in putting as much material as possible on stock to ensure availability. Only a combination of savings and availability targets allows for a suitable alignment of interest between Armed Forces and industry.
From our experience, there are five typical action areas that companies need to address when shifting to PBC.
(1) Improve quality of master data
The existing material management database is usually not in good shape. Without proper master data it is impossible to derive demands or order material correctly. This point may appear trivial, but usually involves extensive preparatory work.
(2) Refine predictive models
The second action area deals with the planning of material consumption. The forecasted demand is often based on historical data only. Demand planning can be enhanced by approaches such as predictive maintenance or the use of “big data”. Automating replenishments via modern ERP systems leads to further efficiency gains.
(3) Introduce a differentiated material management
The procurement and inventory strategy should be based both on the quality of the material and on the predictability of demand. An ABC / XYZ analysis is helpful in this context. For example, for high-value material with high predictability a just-in-time delivery by the supplier is preferred, whilst high-value material with low predictability of demand should be addressed by a supplier reserve. For the large number of C materials (small parts, standard parts, replacement parts, low-priced materials, etc.) it is often more cost-effective to outsource the management to external service providers. It is crucial to ensure lean ordering, storing and booking processes so that the process cost does not exceed the actual value of the items.
(4) Manage supply chain risks
There are often surprises when it comes to lead times and one-off costs. Due to budgetary constraints of the Armed Forces, in many cases in the past there has been insufficient procurement of spare parts and obsolescence management has been neglected. Often, a gradual amendment of framework contracts along the entire supply chain is necessary to secure the required performance.
(5) Measure and improve logistic processes
To achieve long-term cost savings, process efficiency in the areas of procurement, warehousing and logistics must be measured and continually improved. In this context, the new discipline of process mining creates full transparency of process cycle times and process deviations and helps identifying comprehensive approaches for process optimisation.
As a conclusion, it can be stated that PBC agreements provide an opportunity to expand the services business. To achieve cost savings and efficiency gains, it is necessary in our experience to implement a change management to develop a service and performance culture, besides introducing extensive changes to the organisation and processes.