Hot new model: Guaranteed savings contracts

Steven Pearlstein
Columnist October 27, 2012

I’m a sucker for innovative new business models, new ways of organizing the way products and services are produced, marketed and priced.

Years ago, I got fascinated with the new way Harnischfeger, a Milwaukee-based maker of earth-moving and extraction equipment, was marketing to the mining industry. Instead of just selling big machinery to miners, Harnischfeger offered something akin to a leasing-and-maintenance arrangement in which the price was set based on the number of tons of coal or iron ore extracted.

Steven Pearlstein is a business and economics columnist who writes about local, national and international topics. View Archive

Under this arrangement, Milwaukee-based Harnischfeger would own the equipment and, over the life of the contract, be responsible for maintaining it or replacing it whenever there was a breakdown. For the mine owners, the advantage was that Harnischfeger was effectively providing financing for the equipment and assuming some of the risk from any slowdown in coal production. By turning a potentially risky capital investment into a predictable operating cost, Harnischfeger — now part of Joy Global — made it easier for mining companies to provide their customers the longer-term, fixed-price supply contracts they demanded.

Similar arrangements developed in other industries, from computers, office copiers and medical equipment to pharmaceuticals and shipping. Some of them have stood the test of time, others not, but all were part of a broad outsourcing trend that sought to take advantage of economies of scale, turn fixed costs into variable costs, and turn manufacturing firms into service companies while shifting pricing risks from downstream customers to upstream suppliers.

I was reminded of all this last week reading an article — okay, it was in the New York Times — about the growing popularity of energy-savings performance contracts offered to governments and corporations. Under these arrangements, a big energy or engineering firm offers a public or private enterprise a plan to reduce its energy costs and consumption, some of it through conservation or changes in operation but usually most of it through investment in lower-cost or higher-efficiency equipment. The innovative twist is that the energy savings are actually guaranteed by the provider, which makes it easier and cheaper to finance these energy-saving investments. In some instances, the energy or engineering company also takes the credit risk and finances the project as well.

We’ve already seen a similar development in the legal business. Some large law firms have arrangements with big corporate clients to do all of the company’s legal work, or all of it in a given area, for a fixed annual fee. The law firms get to look at several years of legal bills before making their fixed-price offer. Obviously, neither the law firm nor the client knows all of the legal services that will be required in the future, but by sharing some of that risk with clients, law firms are able to lock in a customer’s business and guarantee a steady stream of income that makes it easier to borrow working capital and manage the ups and downs of its business.

One can imagine a similar approach being taken in the relationship between companies and those high-priced strategy consultants. After years of watching as consultants dropped their chart-filled reports on boardroom tables and walked away to the next assignment, clients have been demanding that the consultants stick around for the implementation stage where good strategies often fail. Why not take that pay-for-performance philosophy to its logical conclusion and peg the consultants’ fee to measurable improvements in targeted results?

The health-care sector is moving rapidly in this direction by organizing itself into “accountable-care organizations” — doctors and hospitals that agree to provide and manage all of a person’s health care for the year for a fixed price. The idea is to shift health risks — the risk that you’ll get really sick and need a lot of expensive care — from insurers and patients to health-care providers, on the theory that they will then have the necessary incentives to keep you healthy and provide care in the most cost-efficient manner.

Given the amount of needless — or needlessly expensive — care that is delivered, ACOs offer the prospect of improving health outcomes while saving hundreds of billions of dollars annually. Some of those savings will have to be shared with patients who, by signing up with an ACO, agree to give up the option to use other doctors or hospitals. The open question is whether there will be sufficient competition among ACOs and insurers to produce additional savings for the government (Medicare, Medicaid) or employers who together now pay most of the health-care bill.

What would a guaranteed performance contract look like in education?

One could imagine education companies contracting with under-performing elementary schools to create, equip and staff new math and English laboratories and take over the teaching of these subjects. School systems could demand that the price per student could be set at a significant discount from current costs, with additional bonus payments tied to improvement in student performance on standardized tests. Such contracts could be structured to encourage the hiring of current teachers, who would share in some of the financial gains, along with the other teachers in the school. The real savings would come not from driving down teacher pay but from the more intensive use of technology and new teaching software.

I realize that private education companies have had mixed success in offering such fixed-price contracts, which usually involve taking over entire schools and almost always generate lots of political push-back. Starting with one or two subjects in lower grades would seem a better and more politically acceptable way to start.

In higher education, one can imagine firms offering guaranteed-savings contracts for the development of a general education curriculum for freshmen and sophomores based on guidelines provided by the faculty. The savings would come from making intensive use of videotaped lectures from the school’s best teachers, along with other digital content and off-the-shelf interactive software that monitors student progress through homework exercises, quizzes and tests. Savings could be used to raise faculty salaries and lower student tuition.

Guaranteed performance contracts might also be used to lower costs for some of the bigger items on household budgets.

Just as firms have contracts to help companies manage their fleets of cars and trucks, couldn’t a similar service be offered to households covering leasing, insurance, maintenance and even fueling of their cars? Consumers could get the benefits of sophisticated buying-and-volume discounts, while being spared the time and hassle of shopping around and dealing with different firms.

And what about a similar service for household telecommunications — telephone, TV, Internet — covering equipment, installation, instruction, upgrades and maintenance, all for one monthly fee? My wife can tell you from recent experience that surveying the market and ordering a “bundle” of services can quickly turn into a frustrating part-time job — and even then you’re not likely to get all the promised savings. There’s a business opportunity here for some enterprising geeks.

For years, the economy has become more productive as a result of unbundling services and squeezing out middlemen. It’s been a great run. Going forward, however, I suspect the next round of productivity gains will come from a new iteration of middlemen bundlers who use technology, specialized expertise and economies of scale to guarantee higher quality and lower costs.

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