IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this article

Performance Contracting in After-Sales Service Supply Chains

Listed author(s):
  • 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)

Registered author(s):

    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.

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

    File URL:
    Download Restriction: no

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 53 (2007)
    Issue (Month): 12 (December)
    Pages: 1843-1858

    in new window

    Handle: RePEc:inm:ormnsc:v:53:y:2007:i:12:p:1843-1858
    Contact details of provider: Postal:
    7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA

    Phone: +1-443-757-3500
    Fax: 443-757-3515
    Web page:

    More information through EDIRC

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

    in new window

    1. J. Michael Cummins, 1977. "Incentive Contracting for National Defense: A Problem of Optimal Risk Sharing," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 168-185, Spring.
    2. Fangruo Chen, 2005. "Salesforce Incentives, Market Information, and Production/Inventory Planning," Management Science, INFORMS, vol. 51(1), pages 60-75, January.
    3. George J. Feeney & Craig C. Sherbrooke, 1966. "Correction to "(s - 1, s) Inventory Policy Under Compound Poisson Demand"," Management Science, INFORMS, vol. 12(11), pages 908-908, July.
    4. Jean-Jacques Laffont & Jean Tirole, 1993. "A Theory of Incentives in Procurement and Regulation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262121743, January.
    5. R. Preston McAfee & John McMillan, 1986. "Bidding for Contracts: A Principal-Agent Analysis," RAND Journal of Economics, The RAND Corporation, vol. 17(3), pages 326-338, Autumn.
    6. Holmstrom, Bengt & Milgrom, Paul, 1991. "Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design," Journal of Law, Economics, and Organization, Oxford University Press, vol. 7(0), pages 24-52, Special I.
    7. Erica L. Plambeck & Terry A. Taylor, 2006. "Partnership in a Dynamic Production System with Unobservable Actions and Noncontractible Output," Management Science, INFORMS, vol. 52(10), pages 1509-1527, October.
    8. Jan A. Van Mieghem, 2007. "Risk Mitigation in Newsvendor Networks: Resource Diversification, Flexibility, Sharing, and Hedging," Management Science, INFORMS, vol. 53(8), pages 1269-1288, August.
    9. Kut C. So & Christopher S. Tang, 2000. "Modeling the Impact of an Outcome-Oriented Reimbursement Policy on Clinic, Patients, and Pharmaceutical Firms," Management Science, INFORMS, vol. 46(7), pages 875-892, July.
    10. Ananth V. Iyer & Leroy B. Schwarz & Stefanos A. Zenios, 2005. "A Principal-Agent Model for Product Specification and Production," Management Science, INFORMS, vol. 51(1), pages 106-119, January.
    11. Yunzeng Wang & Morris A. Cohen & Yu-Sheng Zheng, 2000. "A Two-Echelon Repairable Inventory System with Stocking-Center-Dependent Depot Replenishment Lead Times," Management Science, INFORMS, vol. 46(11), pages 1441-1453, November.
    12. G. J. Feeney & C. C. Sherbrooke, 1966. "The (S - 1, S) Inventory Policy Under Compound Poisson Demand," Management Science, INFORMS, vol. 12(5), pages 391-411, January.
    13. Xuanming Su & Stefanos A. Zenios, 2006. "Recipient Choice Can Address the Efficiency-Equity Trade-off in Kidney Transplantation: A Mechanism Design Model," Management Science, INFORMS, vol. 52(11), pages 1647-1660, November.
    14. F. M. Scherer, 1964. "The Theory of Contractual Incentives for Cost Reduction," The Quarterly Journal of Economics, Oxford University Press, vol. 78(2), pages 257-280.
    Full references (including those not matched with items on IDEAS)

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    When requesting a correction, please mention this item's handle: RePEc:inm:ormnsc:v:53:y:2007:i:12:p:1843-1858. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mirko Janc)

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.