Reliability or Inventory? An Analysis of Performance-Based Contracts for Product Support Services

Abstract

Traditional sourcing arrangements for after-sales product support have centered around physical assets. Typically, a customer would pay the supplier of maintenance services in proportion to the resources used, such as spare parts, that are needed to maintain the product. In recent years, we have witnessed the emergence of a new service contracting strategy called performance-based contracting (PBC). Under such a contractual relationship, the basis of supplier compensation is actual realized uptime of the product. In this study we build a game-theoretic model and compare the inefficiencies arising under the traditional resource-based contract (RBC) and PBC. In both cases, the customer sets the contract terms, and as a response, the supplier sets the base-stock inventory level of spares as well as invests in increasing product reliability. We…find that PBC provides stronger incentives for the supplier to invest in reliability improvement, which in turn leads to savings in acquiring and holding spare product assets. Moreover, the efficiency of PBC improves if the supplier owns a larger portion of the spare assets. Our analysis advocates the view that the full benefit of a PBC strategy is achieved when suppliers are transformed into total service providers who take the ownership of physical assets.