Finding and Funding IT Projects, Part 3: Performance Contracting

A vendor/agency partnership can build stronger solutions to IT problems.

by , / February 28, 1998
Getting good IT funded is a huge problem for many governments. Some of the best projects require multiple years of effort and/or cooperation among many agencies -- an all-too-apt description of the kind of opportunity the annual budget process usually ignores.

In response, many governments are turning to creative funding that relies less on traditional tax-levy budgets. One of the most attractive options is performance contracting, or shared-risk, public/private ventures. According to JD Williams, the Idaho state controller: "In this day of tight budgets and the need to have smaller but smarter government, performance contracts offer another arrow in the quiver to serve our people."

This is the third in a series of four articles drawn from the forthcoming Government Technology guidebook on funding information technology projects in the public sector.

The California Franchise Tax Board has written a report about its financing project entitled "Performance Based Procurement: Another Model for California." The report is available on the Internet at .


Performance contracting is based on the principle that incentives should focus attention on valued outputs (service levels or efficiencies, as in total revenues collected by a revenue agency or administrative costs per dollar collected), not merely on needed inputs (worker hours, needed hardware or software, etc.). The key idea is this: Keep your eyes on the prize and some of the contractor's skin in the game.

Under traditional contracts, IT vendors are asked to supply tightly specified inputs. They are not asked to apply their in-depth and often proprietary technology expertise to creatively improve government outputs. In fact, they are discouraged from offering anything other than narrowly solicited advice, since they would not gain much themselves (the government would typically turn the vendors' ideas into bid specs for broadcast to competitors), and/or they would become vulnerable to charges of tampering with the bidding process. As a result, there are far too many cases where vendors have kept silent as government blithely proceeded to ask for the wrong technologies.

By their nature, performance contracts give vendors better incentives to address broader problems and offer their full range of expertise. To the extent that the desired output is a revenue increase or a cost decrease, the contractor may be willing to be paid out of "found" money, and worthy projects may proceed even though funding is not in hand at contract time. When this happens, it clearly helps solve the funding problem.


California's Franchise Tax Board (FTB) found itself with a problem: As collector of corporate taxes, its workflow -- manual and paper-intensive -- detracted from its ability to close the gap between taxes owed and taxes paid. Uncollected taxes amounted to some $700 million. Decision-makers at the FTB knew they needed the kind of breakthrough that could only be accomplished by a complete redesign of their tax accounting and business systems. Yet this would require new technology and expertise, and the FTB lacked many of the skills and resources needed. Further, technology procurement had become increasingly inefficient. The period between requesting and receiving equipment often extended nearly two years -- an eternity in the rapidly changing field of technology.

To solve these problems, the FTB turned to performance contracting, characterized by three primary features: partnerships with vendors, the conceptual proposal and risk sharing.

* Partnerships -- The FTB first developed "Strategic Partnership Alliances" with a number of interested vendors by prequalifying them to compete for certain proposals. By forming a pool of vendors, the FTB sought to develop long-term, mutually beneficial relationships characterized by trust, cooperation and mutual learning, while still preserving discipline by keeping a number of vendors in the hunt. The partnership approach is particularly valuable for complex projects, since complexity requires in-depth cooperation
that can only be fully achieved over a reasonably long period of time.

* Conceptual proposals -- As it identifies organizational problems, the FTB solicits its prequalified vendors for "conceptual proposals." As replacements for the traditional request for proposal, the request for conceptual proposals defines the problem and desired results (where the FTB has the most knowledge), not the details of technological solutions (where the vendors have the most knowledge). Vendors are free to propose whatever solutions they feel are best, but they must specify anticipated benefits, costs, and results. The FTB then works with the bidding vendors throughout a period of critique and evaluation to develop the best solution overall. While this process is competitive among the prequalified vendors, it is not adversarial between the vendors and the FTB. Openness guides the process and is extended to bidders who don't win contracts; in all cases the FTB explains its decision-making without revealing proprietary information.

* Risk sharing -- Perhaps the most attractive feature of performance contracting is that risks don't fall so heavily on government but are shared more equitably between the agency and winning vendor. The vendor can be paid if and when the contracted-for objectives are achieved (e.g., more efficient revenue collections, lower unit service costs). Because of this, vendors are motivated to work closely with the agency to develop solutions that most quickly and feasibly deliver the outputs and outcomes sought. When both parties pursue the same goal and face risks together, they can work better together to create success.

The FTB found that performance contracting reduced the time required to bring a project to fruition and has yielded high-quality solutions. A $5 million contract was made operational within nine months instead of the 24 months normally considered "reasonable" in the California contracting environment. Working closely together throughout design and implementation, the FTB and the vendor created new systems and procedures that were adopted without the major glitches and finger pointing that had marred other highly visible California IT projects. Perhaps most important, the project proceeded without high up-front budget set-asides, since funding came from taxes left uncollected under previous systems and procedures. For the FTB, the vendor and the citizens of California, this has been a win-win-win.


The FTB's experience demonstrates that performance contracting can work well in some cases. The key is to identify settings where organizational outputs and/or social outcomes can be adequately measured and controlled by the agency and contractor working together. Revenue collection offers many such opportunities, but many others exist in education, social services, health care, environmental protection, and almost any service where good IT could improve productivity.

Along with the upside potential, however, performance contracting also brings some notable downside risks:

* Cost-accounting difficulties -- Key productivity targets typically involve a reduction in the unit costs of service delivery. But governments often don't know their true costs, and the activity-based costing required to get workable figures can be difficult and sometimes arbitrary, especially when agencies produce many services with complex overhead relationships. For example, if the service involved is "providing motor vehicle data to corporations," how much of the cost of data collection should be allocated to that service as opposed to the related service of "protecting highway safety," which collects the same data in the course of licensing vehicles? And what costs from the governor's office or statewide budget office should be allocated as overhead to either of these services?

* Internal power struggles -- Replacing input specifications with output specifications can be viewed as taking control away from some people -- especially those in charge of the procurement process -- and giving it to others. Note that the FTB story is primarily about agency managers, not about procurement officials or the state CIO.

* Vendor reluctance -- Vendors often see performance contracts
as risky. While valuable ventures are always somewhat risky, a vendor may feel too vulnerable if, for example, it feels it would have little control over activities the government must perform to reach a given performance target. As a result, some vendors may choose not to participate.

* Adverse selection -- If the best vendors are unwilling to participate, however, the vendors who are willing might be precisely those that the government isn't or shouldn't be interested in working with.

* Political adjustments -- Even when vendors choose to play, there are still potential problems. Vendors who realize a return -- particularly if the government frequently contracts with them -- run the risk of looking too successful, thus giving rise to calls to spread the work around. Further, regardless of how the "ex ante" risk was portioned between government and the vendor, it may be hard to withstand pressures to make adjustments for the politically connected once the "ex post" realities play out. Such long-term adjustments and gaming have taken place in defense contracting, for example, for large weapons systems as well as other technology-related projects.

* "Cozy" relationships -- A vendor who repeatedly wins contracts may either be building a socially valuable working relationship with government and/or a too cozy, ripe-for-abuse relationship, at least in the eyes of elected officials or the public. Indeed, losing firms might make this very charge.

The above pitfalls are not stop signs but warnings to proceed with appropriate care. There are many places where performance contracting is not yet utilized but could be extremely relevant. As Ralph Shoemaker, assistant executive officer of the California FTB said, "It's time government begins paying vendors for solutions that add value to our bottom line, not just for hardware and software."

Jerry Mechling is director of Strategic Computing and Telecommunications in the Public Sector at Harvard University's John F. Kennedy School of Government. Victoria Sweeney is a research affiliate with the same program.

March Table of Contents

Jerry Mechling Contributing Writer