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

Abstract

Using a proprietary dataset provided by a major manufacturer of aircraft engines, we empirically investigate how product reliability is impacted by use of two different types of after-sales maintenance support contracts: time and material contracts (T&MC) and performance-based contracts (PBC). We offer a number of competing arguments based on the theory of incentives that establish why product reliability may increase or decrease under PBC. We build a two-stage econometric model that explicitly accounts for the endogeneity of contract choices, and find evidence of a positive and significant effect on product reliability created by the incentives under PBC. The estimation of our model indicates that product reliability is higher by 25-40% under PBC compared to under T&MC, once the endogeneity of contract choice is accounted for. Our results are consistent with two mechanisms for reliability improvement under PBC: more frequent scheduled maintenance and better care performed in each maintenance event.