Performance-Based Logistics: Incentive Contracting in the Aftermarket

Traditional sourcing arrangements for after-sales support of capital-intensive products such as airplanes, weapons systems, and manufacturing equipment have centered around physical assets such as spare parts, which were the unit of financial transactions. In recent years, we have witnessed the emergence of a new service contracting strategy called Performance-Based Logistics (PBL). Under PBL, the basis of supplier compensation is actual service outcome, such as uptime of the product. In this dissertation, we study three major issues that practitioners in the aerospace and defense industry are facing today. In the first part of the dissertation, 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 service parts inventory investment levels. We find that the optimal 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. The second part of the dissertation compares the inefficiencies arising under the traditional (pre-PBL or material contract) and the PBL contract, and their respective impacts on motivating the supplier to improve product reliability. We find that the PBL contract provides stronger incentives to invest in reliability improvements than does the material contract. Moreover, our analysis supports a DoD recommendation for transforming suppliers into total service providers of support services who, under the PBL arrangement, assume complete control of service functions, including asset ownership. In the third part of the dissertation, we investigate how the infrequent nature of product failures impact efficiency of PBL contracting. We show that a seemingly innocuous choice of performance measures used in contracts may create unexpected incentives, resulting in counterintuitive optimal contract structures. We also find that, paradoxically, a firm that values high product reliability may also have to cope with excessive contracting costs.