Pay For Results, Not Effort

The Department of Defense has eschewed time-and-materials contracts since 2004. There's good reason.

Suppose you are a hedge fund manager, and you have a $100 million hedged position, but you can't trade for 15 seconds because your Internet router goes down. How much could it cost you? That question is posed by Morris A. Cohen, professor of operations and information management at Wharton. Even during the recent stock market slump, the sum would be considerable, which is why hedge fund managers want to make sure such incidents are few and far between. One way to do that, says Cohen, is to set up a performance-based contracting (PBC) arrangement with an IT service provider, which would charge a fee based on the amount of time it provides uninterrupted Internet access.

But if you took Cohen's advice, would you be getting better value than if you paid the IT service provider for repairs every time your Internet connection was down? It's a question that Cohen has spent the past several years researching with Sang-Hyun Kim, a professor at Yale University's School of Management; Wharton operations and information management professor Serguei Netessine; and Wharton doctoral student Jose A. Guajardo. According to the researchers, they now have breakthrough evidence that supports PBC, which they outline in a forthcoming paper titled, "Impact of Performance-Based Contracting on Product Reliability: An Empirical Analysis."

PBC--also known as performance-based logistics (PBL) or power by the hour (PBH) in some circles--isn't new, though its use has been limited. Often associated with maintenance agreements at aerospace and defense companies, it was first embraced by the likes of U.K.-based aircraft engine manufacturer Rolls-Royce ( RYCEY.PK - news - people ) some 30 years ago.

But under pressure to cut costs and improve efficiency, others have hopped on the bandwagon more recently. A case in point: the United States Defense Department, which has required widespread adoption of PBC for new military equipment since 2004. More companies should follow suit. The reason? According to its proponents, PBC is the most economical way to cover the maintenance costs of big-ticket items like F-22 fighter jets and commercial airplanes. They add that PBC increases the reliability of these items by decreasing the number of major repairs they need.

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There's other good news for cost-conscious companies. With PBC, it's easier to keep a lid on overall capital expenditure. "By extending the service interval, you end up buying fewer engines because you get more capacity utilization," Cohen notes.

However, proving the validity of these claims has been difficult. A report from the Government Accountability Office a few years ago chided the Defense Department shortly after it adopted its PBC policy, given the lack of hard evidence that such contracts save money. The GAO also questioned whether the performance of Defense Department equipment improved more under PBC than under traditional time and materials (T&M) contracts, which require customers to pay for what is consumed each time equipment needs maintenance or repair.

While the GAO report stirred policy debates and prompted congressional hearings, it also encouraged academic supply-chain management experts to step up research on the benefits of PBC. One result is the new study by Cohen, Netessine and their colleagues showing--for the first time--that the performance of commercial jet engines is between 10% and 25% more reliable with PBC than T&M contracts. As Cohen notes, the findings could have a major impact on suppliers' customer-relationship management and after-sales support strategies.

Pay Now, Pray Later

Using five years of maintenance records at Rolls-Royce for some 700 products at more than 60 customers, the researchers found that the time between engine overhauls increased by 790 hours on average when PBC is used. Along with a significant reduction in maintenance costs, the difference also had a positive impact on down time. As Cohen explains, an airline with a Boeing 747 in maintenance "could lose hundreds of thousands of dollars for each day the plane is out of service. Because down time is very expensive, PBC is a way to maximize the plane's availability or 'up time.' "

The latest research should spur suppliers to use PBC and "convert tangible products into a service," says Cohen. Boeing, for example, now sells a maintenance, repair and materials management package with its newest airplane, the 787 Dreamliner. Called GoldCare, the package's various services promise to increase airplane availability, reduce costs and improve efficiency throughout the life cycle of a 787. "Before, we were just selling parts; now we are selling airlines a 'power-by-the-hour' service," according to a Boeing executive.

But until recently, most suppliers have preferred to stick with traditional, more lucrative T&M contracts. It's easy to see why. For every dollar earned selling aircraft, the aerospace industry earns an estimated seven times as much by selling parts and service over the aircraft's lifetime. Given that aircraft maintenance and repairs amount to $117 billion a year, including $60 billion in military spending, it's big business. "Suppliers are reluctant to sign up for PBC because they could lose money," says Cohen. "There's a lot of uncertainty about whether it's going to work and how much it's going to cost because we haven't had the data."

Part of the challenge of getting corporate supply-chain executives to acknowledge the benefits of PBC has been that researchers haven't had access to data to track a product's history of repairs under both PBC and T&M contracts. At organizations like the Defense Department, gathering such data usually isn't possible because equipment is covered by only one contract type at a given time. Gathering data from commercial enterprises, however, is more promising because customers are often offered both contracts simultaneously. But even then, companies are reluctant to share information about repair costs for competitive reasons. "The challenge of this kind of research is that it takes years to get the data," says Cohen.