How to Include a Performance Contract in Your Capital Expenditure

Published on Tuesday, 15 October 2013 06:04:39    Written by Marc
Capital expenditure can be about many things, ranging from building to production equipment and many things in between actually. Regardless what the capital expenditure is about, it normally has its own specs. For example, if we seek a capital expenditure for the construction of a building expansion, the things we will look at will be different from a capex for production equipment. While is obvious, what is less is what we need to look for in order to insure that the result mirrors what we really wanted in the first place.

performance clauseIf we need new production equipment for assembling widgets and we manage to find the perfect widget maker that can assemble 5,000 widgets per hour, one way to insure that the manufacture will deliver us what we need is to specify a performance clause. In our case here, the simple method would be to specify in the purchase contract that the manufacturer’s equipment would need to deliver 5,000 widgets per hour (and according to measurable specs).

However, what if the equipment delivers 4,700 widgets per hour? Do you return the widget assembler on the basis that the manufacturer did not respect the agreement and go buy another widget assembler from another company? What if this is the best and fastest widget assembler in the world? Sometimes the answer of what to do is clear-cut: The widget assembler cannot produce a single widget. Nevertheless, in other cases, when problems arise you find yourself scrambling to think about potential solutions.

Having a performance clause on a capital expenditure project or equipment is good. Defining it in details and coming up with a plan B is better. For example, if the goal is to purchase a widget assembler that can assemble 5,000 widgets per hour, if you can live with a lower level of performance, you will need to know what compensation you want to seek depending on what will be the actual measured performance of the equipment.

You will also want to set a minimum level at which the manufacturer will take back the equipment to get a refund. Also, setting a time limit for the manufacturer to achieve the desired level of performance is important because if not, you might find yourself getting requests after requests for ‘one more week’ of patience from the manufacturer while he/she tries to get the equipment running to where you need it.

Moreover, since you usually do not want or have time to serve as a guinea pig, especially if the product is a new type or even worse, untested, setting a time limit will set the rules from the start. Finally, do not forget to fully understand exactly what the manufacturer from you (or your company) requires. If the manufacturer specifies a level of productivity only on the condition that you do or provide something in return, make sure you can deliver.

I remember equipment we purchased once, an absorption chiller, which was supposed to produce roughly 300 tons of cooling, providing we supplied a certain volume of heated air. Turned out our own equipment were not always operating at full capacity and rarely did we produce the required quantities of heated air and when the quantities where there, the temperature was not high enough according to the manufacturer. The result was a poor performance of the equipment and the manufacturer was hardly to blame but the people in our company did not really care, the general opinion was that the manufacturer failed to deliver a quality product. In this case, everyone loses.

Take time to set performance clauses but also take time to make sure you will deliver on your side of the terms. Create a fallback plan that you can live with in case the performance of the purchased goods/equipment/other is not completely met. If your performance is based on quantity, define what you will accept in the contract. Same if the performance basis is quality, you will need to define as best possible what constitutes quality and what does not. For example, if you purchase equipment that produces sheets of a product that needs to be exactly the same thickness each time, make sure you specify this and validate the tolerances that the manufacturer will claim.

For example, if the manufacturer claims his/her equipment can meet the thickness request with a tolerance of plus or minus (+/-) 2 percent (2%), you need to know in advance what you will want to do if the equipment ends up producing the product with a 3 percent (3%) tolerance. Will you accept the equipment, seek a form of compensation, or return the equipment. Defining precisely what each party will be responsible for in the contract will help. In doubt, consult with a legal counsel; they are often of great value for these types of contracts where you need to define more complex performance clauses. In the end, these few steps will save you many headaches and avoid you leaving scrambling to finding alternatives when things do not go completely well.