Equipment one encounters in the aerospace industry is very complex: think about an aircraft engine.  It is, in fact, so complex that airlines usually have a separate agreement with the engine maintenance provider, often the same company that manufactures the engines.  We are probably all familiar with repair and maintenance services through the car dealership: they will charge you for parts AND labor, and you can rarely tell upfront how much. So about 30 years ago Rolls-Royce came up with an innovative customer proposition: provide exact same service for exact same products, but charge customers per flying hour of the engine.  Why is this different enough to be liked by many customers?  And why is this attractive enough to inspire entire US Department of Defense to source all services this way?

Forecasting how often equipment will break down and how much money will be spent repairing it is a major pain for an airline.  The airline does not really want to stock spare parts and hire repair labor: all it wants is the engine to fly. This is exactly what Power-by-the-Hour contract offers: buy functionality (flying engine) and not spare parts.  In fact, the company selling you parts and labor has direct incentive to sell more of it: remember all these horror stories about unnecessary car repairs? Well, under Power-by-the-Hour no more of that: both the service provider and the customer care about the same thing, the flying engine.  And if you think about it, the service provider might actually try to perform more preemptive maintenance (flying time is money – downtime is not!) or maybe even design a better engine.  This is exactly what our empirical study of Rolls-Royce engines demonstrated.

Based on the phenomenal success of Power-by-the-Hour in the commercial aviation sector, The White House implemented similar approaches to sourcing most services.  And the Department of Defense declared that performance-based contracting is the only way to source services starting from 2003.  If you think that offering performance-based maintenance is easy then think again: this requires detailed understanding of the risk involved in equipment breakdowns. Essentially, the risk is transferred from the customer to the service provider so one needs to be able to price it correctly. Of course, the equipment manufacturer is often best positioned to manage this risk since he sees data from numerous pieces of equipment so transferring the risk to the manufacturer makes economic sense. This is yet another example of the renaissance innovation, the systematic approach that companies can use to innovate industries in a fundamental way by better managing risks, in this case by taking more of it but charging the price premium.