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

26 Pages Posted: 27 Aug 2010 Last revised: 6 May 2015

See all articles by Sang-Hyun Kim

Sang-Hyun Kim

Yale School of Management

Morris A. Cohen

University of Pennsylvania - The Wharton School

Serguei Netessine

The Wharton School, University of Pennsylvania

Date Written: May 6, 2015

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.

Suggested Citation

Kim, Sang-Hyun and Cohen, Morris A. and Netessine, Serguei, Reliability or Inventory? An Analysis of Performance-Based Contracts for Product Support Services (May 6, 2015). INSEAD Working Paper No. 2015/36/TOM. Available at SSRN: https://ssrn.com/abstract=1666100 or http://dx.doi.org/10.2139/ssrn.1666100

Sang-Hyun Kim

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Morris A. Cohen

University of Pennsylvania - The Wharton School ( email )

Philadelphia, PA 19104
United States

Serguei Netessine (Contact Author)

The Wharton School, University of Pennsylvania ( email )

3730 Walnut Street
Philadelphia, PA 19104-6367
United States
(215) 573 3571 (Phone)

HOME PAGE: http://www.netessine.com

Register to save articles to
your library

Register

Paper statistics

Downloads
218
Abstract Views
1,031
rank
140,939
PlumX Metrics