Privatization of government assets and services is nothing new these days. But new ideas to facilitate privatization and ensure that it is successful are continually evolving. One such idea is the "performance-based" contract, a privatization tool that can yield tremendous benefits when implemented correctly, but which also contains a number of pitfalls. This article will help government officials devise strategies to avoid those pitfalls.

Performance-Based Contracting

A performance-based contract is one in which government spells out what final product they want but leaves to the contractor the discretion for achieving the objective. These contracts give public officials the opportunity to design public-private agreements that are tied to some performance objective. The most aggressive of these contracts are known as "share-in-savings" contracts because contractors get paid based on a percentage of what they save the public agency.

For instance, one public administration scholar has noted that

  • The U.S. Department of Education contracts with 17 collection agencies who are paid a flat fee of 27% of all student loan money brought in from delinquent federal loans. The contracts also provide an incentive bonus given to top collectors every four months. The department pays for nothing up front and still gets back a large percentage of the initial loan.

  • An agency within the U.S. Department of Agriculture is currently negotiating a share-in-savings contract for a private vendor to perform its payroll services. Under the terms of the agreement, the agency will save up to $45 million it would have spent for payroll software to handle 500,000 employees. Instead, the private firm donates the software in exchange for the opportunity to collect a fee for every person paid with it. The contract is estimated to be worth between $30 and $45 million.

Still, share-in-savings contracts provide no magic elixir. In their article entitled "Strategies for Avoiding the Pitfalls of Performance Contracting," published last year in Public Productivity & Management Review, scholars Robert Behn of Duke University and Peter A. Kant of the Department of Agriculture say performance contracting

  • Inhibits experimentation with new service delivery techniques to minimize uncertainty.

  • Encourages innovation in cost cutting but not in service delivery. In other words, if a contractor can find less expensive ways of delivering the same product, he benefits. However, what incentive does he have to deliver a better product than is called for in the contract?

  • Inhibits a symbiotic relationship between government and contractors. In the private sector companies have an incentive to establish friendly, open relationships with their subcontractors. In government, strict adherence to fairness prohibits such relationships from developing and can make the contracting process less efficient.

  • Rewards promises rather than performance. Contractors have an incentive to make grand promises. It is incumbent upon public officials to ensure that contractors make reasonable claims and follow through.

  • Relies on measures that may distort behavior. If public officials author contracts without specifying their objectives precisely, the contractor may fail to produce the desired results.

Avoiding the Pitfalls

These and other pitfalls can be avoided if officials adhere to a few rules of thumb. For instance, selecting the right contractor is as important as writing a sound contract. Public officials should ask for qualifications and references of potential contractors to weed out those with little or no previous experience.

Another rule is to write provisions into contracts that require monitoring of specific services. Methods for monitoring, as outlined by the Reason Foundation, a policy research organization in California, can include everything from periodic and surprise inspections to customer surveys. An important point to remember is that some contracts require more or less monitoring than others, and it is sometimes profitable to simply specify the desired result and let contractors find a way to accomplish your goals.

Probably the most important rule for ensuring success with performance-based contracts is to provide, when possible, market-style incentives for contractors and public officials to fulfill their respective ends of the bargain. For instance, in Pleasant Ridge, a tiny bedroom community in Oakland County, the city commission contracted out with City Municipal Services Inc. to provide public works services such as tree trimming and, to help guarantee quality, wrote a bonus plan into its contract. The company could keep half of any savings realized from the contract after it saved the city 30% on any service being provided.

As privatization deals grow in size and complexity they will require greater and greater levels of understanding and sophistication on the part of government officials. But performance-based contracts, if handled correctly, can bring the maximum benefits of privatization: better savings and better services.

Michael LaFaive is managing editor of Michigan Privatization Report.