Engaging suppliers for reliability improvement under outcome-based compensations

Many durable products are now servicized with outcome-based contracts under which customers pay for uptime. Outcome-based contracting poses challenges to product support management, because the customers’ losses due to system outages result in penalties for the OEM. Moreover, in many cases product failures are caused by defective subsystems or components that are manufactured by the OEM’s suppliers. Not involving suppliers in product support leads to a lack of incentives for product reliability improvement and thus higher failure rates, which increases product downtime risk. In this paper, we study how the OEM should incentivize its suppliers to improve product reliability under outcome-based contracts. We find that the more recent repair cost sharing contracts perform better than the traditional price-only contracts. However, in the presence of outcome-based contracting, sharing repair cost results in underinvestment in product reliability and overinvestment in repair capacity, which leads to lower system uptime. We then propose a downtime penalty sharing contract which can optimally incentivize the upstream suppliers to improve product reliability, regardless of the repair capacity structure or product separability into constituent parts.