This Article Full Text (PDF) e-companion References Alert me when this article is cited Alert me if a correction is posted Services Email this article to a friend Similar articles in this journal Alert me to new issues of the journal Download to citation manager Citing Articles Citing Articles via Google Scholar Google Scholar Articles by Kim, S.-H. Articles by Netessine, S. Search for Related Content

Performance Contracting in After-Sales Service Supply Chains

The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104
The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104
The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104
shkim{at}wharton.upenn.edu
cohen{at}wharton.upenn.edu
netessine{at}wharton.upenn.edu

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.

Key Words: games; principal-agent; replacement-renewal; military; logistics; inventory-production; maintenance-replacement; government; defense
History: Received: January 11, 2006;