The landscape of service contracting is changing, as service providers and customers are replacing traditional agreements with contracts based on agreed outcomes. These outcome-based contracts (OBC) allow customers to buy the outcome of a product or service that is delivered, rather than merely the parts or repair services required for the product or service.
OBCs emphasise the concept of value-in-use, where value is the benefit the customer obtains through using the product or service. This compels the service provider to bring the customer into its sphere to allow the provider to optimise the service delivery together with the customer, in a process that involves both parties co-creating and co-producing value. As a result, the objectives of both the service provider and the customer become much more aligned under OBC.
OBCs are becoming increasingly popular with business-to-business transactions, particularly in the service of supporting and maintaining equipment, such as maintenance, repair and overhaul (MRO) contracts in the defence and aerospace industries. A good example is Rolls-Royce’s Power by the Hour® contract, where the continuous maintenance and servicing of engines are remunerated according to how many hours the customer obtains power from the engine, rather than by measuring the spare parts, repairs or activities rendered to the customer.
OBCs are fast becoming an important component of managing after-sales service supply chains beyond defence and aerospace contracting. It is also permeating into other service industry sectors, such as ‘no win no fee’ offerings from legal firms and revenue sharing models where fees paid to consultancy firms are based on how much savings they can help their customers make.
Why are OBCs becoming increasingly popular? Customers and suppliers are realising that it is not just enough to acquire world-class equipment; they also seek innovative and cost-efficient ways to achieve the same outcomes through reduced production of materials – leading to improved sustainability - and better service and maintenance throughout the useful lifespan of the equipment. They are beginning to see the benefits that OBC can provide in this respect.
Benefits of Outcome-Based Contracting
One major benefit of OBC is that by only paying for a measurable and predictable outcome, customer firms are able to make more accurate cost projections. OBC also helps lower total contract costs, as both the customer and service provider contribute complementary resources towards a joint outcome.
At the heart of OBC lies 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. This better alignment between the interests of both parties means less scrutiny of the service provider is necessary, resulting in lower transaction and monitoring costs. Also, by rewarding them based on delivering measurable outcomes, service providers are incentivised to ensure the equipment they provide is of high quality and delivers the performance as promised.
Service providers also stand to benefit from OBC. Managing OBCs usually leads to greater internal effectiveness as a result of the improved understanding of, and alignment with, the customer’s requirements. This in turn results in higher staff satisfaction and loyalty, while improved effectiveness of service delivery leads to greater customer satisfaction and loyalty.
The closer relationship between the service provider and customer also enables the provider to have greater control and efficiency of service delivery. This in turn facilitates better use of resources and cost efficiencies while still achieving acceptable outcomes, such as through capacity sharing across multiple contracts. This close customer relationship also allows service providers to better anticipate customer needs, and therefore drives innovation to meet the customer’s changing requirements.
An integral part of a successful OBC is the service provider’s ability to manage customers for better co-creation and co-production to deliver the appropriate outcomes. Service providers which become adept at this will develop a unique competitive advantage that can help them secure more future contracts.
OBC is changing the way service providers and customers interact and create value. The role of the customer within the service provider’s delivery space requires new ways of thinking, and shifting to an outcome-based model requires both parties to adopt new skills sets, change attitudes towards the service provider-customer relationship, and acquire a better understanding of how to maximise the advantages of OBCs. It may also prompt a move away from traditional functional organisational structures towards the empowerment of cross-functional service teams spanning multiple organisations.
Challenges for customers and suppliers
While OBC is intuitively appealing to the customer, it however poses a huge challenge for the service provider as it requires a change in its business model. Research has found several organisational challenges that arise from this new business model.
First, the complexity and unpredictability in costs results in the need for a balance between delivering an innovative and effective service capable of dealing with changing circumstances, and the need to forecast costs to ensure that service delivery is economical and profitable. Second, the cultural change resulting from the move away from a traditional business model can cause individuals to question their role and value, hence significant priority must be given to dealing with the effect on individuals within the change process.
OBCs also tend to give rise to a perceived loss of control, both on the part of the customer with regards to its changing role under OBC, as well as with the service provider, where while the complexity and unpredictability can lead to higher monitoring and transactions between management and the support and delivery teams of the firms.
As both the service provider and customer work together to co-produce the outcome, boundaries can also become blurred. Boundaries can either be held rigidly as a result of not fully understanding the roles each party must play, or become fluid with out-of-contract requests being accommodated so as to build better relationships.
Finally, a big challenge for service providers is the coordination with its sub-contractors or suppliers. Issues arise from the need to reconcile and align the OBC with the firm’s suppliers, and to integrate their role within the contracts and fitting their components into the outcomes achieved by the provider with the customer.
To ensure the successful implementation of OBCs, these factors need to be addressed. Some factors that might mitigate these challenges include better and easier access to complementary information, materials and skills; better empowerment of the service provider and also individuals in both firms; the need to transform behaviours and attitudes of employees to ensure better usage of equipment by the customer; encouragement of teamwork both within the service provider firm as well as with its customer, and with its suppliers; acknowledging and addressing the perceived lack of control from the outset; and aligning the service provider’s and customer’s expectations.
Despite the many challenges associated with the transition from conventional to outcome-based contracting, it is highly likely that OBC is the future of business-to-business service contracting. Organisations should therefore prepare to deal with the transformation involved in acquiring true service value delivery capabilities.
Irene CL Ng, is Professor of Marketing and Service Systems at Warwick Manufacturing Group and a Fellow of the Advanced InsFellow of the Advanced Institute of Management Research (AIM Research)
