Performance Contracting in After-Sales Service Supply Chains

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 …xed-price and cost-plus contracts in order 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 theTo analyze implications of performance-based relationships, we introduce a multitask principalagent 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 o¤ers contracts contingent on availability to n suppliers (agents) of the key subsystems used in the product, who in turn exert cost reduction e¤orts and set spare parts inventory investment levels. We show that the …rst-best solution can be achieved if channel members are risk-neutral. When channel members are risk-averse, we …nd that the second-best contract combines a …xed 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.The authors are grateful to the seminar participants at the Wharton School, Cornell University, University of Texas at Dallas, University of Washington, Columbia University, UC Berkeley, and Naval Postgraduate School for helpful discussions. The authors would also like to acknowledge input from L. Gill, S. Gutierrez, M. Lebeau and M. Mendoza, who provided valuable information concerning current practices. Finally, the authors are grateful for the assistance of Ashish Achlerkar of MCA Solutions, who provided valuable assistance in testing the model and providing access to a real-world data set.

Outcome-based contracts as new business model: The role of partnership and value-driven relational assets

“…The firm could also provide the customer with a cost-plus contract with detailed cost structures to ascertain reimbursement with a pre-determined profit percentage (Kim, Cohen & Netessine, 2007). Performance of such contracts are usually assessed based on how quick they respond to breakdowns, the speed in which the equipment can be repaired, how efficient is the scheduled maintained and other activities where there is a measurable way in which the provider's performance could be assessed.…”

“…A number of equipment-based service contracts are moving towards becoming outcome based with hopes of significantly decreasing costs, increasing customer satisfaction and reducing financial audits (Kim et al, 2007). All of this suggests that OBC is a new business model, as it changes the value drivers from billed activities to partnered outcomes (Demil & Lecocq, 2010); changing the focus from value capture to value co-creation (Hedman & Kalling, 2003;Shafer et al, 2005); changing the dominant logic of 'selling to' to 'creating value with' the customer (Nenonen & Storbacka, 2009); and changing the unit of analysis away from the organisation to that of the collaborative value-creating system (Zott & Amit, 2010).…”

Outcome-based contracts as a driver for systems thinking and service-dominant logic in service science: Evidence from the defence industry

“…Traditional MRO contracts are contracted under a MRO service level agreement where the cost of spares could be excluded, or where spares are included in the price (Van Weele 2002). The contractor could also provide a cost-plus contract provide detailed costs structures (inclusive of a schedule of cost of spares) to the customer to determine reimbursement with a profit percentage that has been predetermined (Kim et al 2007). Recently, there have been a growing number of MRO contracts that focuses on outcomes of equipment rather than the tasks involved in the provision of the equipment.…”

“…Overall, there is more equitably aligned risks and incentives between suppliers and customers in outcome-based contracting than in traditional contracting (Kim et al 2007). As such, we are beginning to find more B2B services contracts moving towards outcomebased incentives with hopes of witnessing significant decreases in costs, significant increases in customer satisfaction and the reduction of financial audits .…”

Impact of Performance-Based Contracting on Product Reliability: An Empirical Analysis

“…As a consequence, most observers expect that the adoption of PBC will lead to more effective value creation, i.e., with a higher level of performance and a lower cost to the customer, as well as a higher level of profit to the supplier of support services. A growing body of literature (e.g., Kim et al 2007Kim et al , 2008Kim et al , 2009) analyzes this issue from an economic and operations modeling perspective. The results of that research indicate that it is possible to design coordinating contracts based on performance and that under such contracts, suppliers and customers have a strong incentive to increase product availability through various means that include improving support capabilities, investing in an appropriate level of support resources, and improving the underlying reliability of the products.…”