Performance Contracting in After-Sales Service Supply Chains

Sang-Hyun Kim (), Morris A. Cohen () and Serguei Netessine ()
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Sang-Hyun Kim: The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104
Morris A. Cohen: The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104
Serguei Netessine: The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104

Management Science, 2007, vol. 53, issue 12, 1843-1858

Abstract: Performance-based contracting is reshaping service support supply chains in capital-intensive industries such as aerospace and defense. Known as "power by the hour" in the private sector and as "performance-based logistics" (PBL) in defense contracting, it aims to replace traditionally used fixed-price and cost-plus contracts to improve product availability and reduce the cost of ownership by tying a supplier's compensation to the output value of the product generated by the customer (buyer). To analyze implications of performance-based relationships, we introduce a multitask principal-agent model to support resource allocation and use it to analyze commonly observed contracts. In our model the customer (principal) faces a product availability requirement for the "uptime" of the end product. The customer then offers contracts contingent on availability to n suppliers (agents) of the key subsystems used in the product, who in turn exert cost reduction efforts and set spare-parts inventory investment levels. We show that the first-best solution can be achieved if channel members are risk neutral. When channel members are risk averse, we find that the second-best contract combines a fixed payment, a cost-sharing incentive, and a performance incentive. Furthermore, we study how these contracts evolve over the product deployment life cycle as uncertainty in support cost changes. Finally, we illustrate the application of our model to a problem based on aircraft maintenance data and show how the allocation of performance requirements and contractual terms change under various environmental assumptions.

Keywords: games; principal-agent; replacement-renewal; military; logistics; inventory-production; maintenance-replacement; government; defense (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (93)

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