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

Using a proprietary dataset provided by a major manufacturer of aircraft engines, we empirically investigate the impact of incentives present in after-sales repair and maintenance support contracts on product reliability. In particular, we compare the reliability of products under time and material (T&M) contracts, which have been used traditionally in the airline industry, with the reliability under performance-based contracts (PBC), which are gaining wide acceptance. We discover that there is inherent endogeneity in contract choices by the customers. To account for this endogeneity, we estimate a two-stage econometric model, and find that larger customers and users of certain equipment types are more likely to select PBC over T&M contracts. After controlling for this selection process, we find evidence for the positive and significant effect of performance incentives created by PBC on product reliability. Our estimates indicate an improvement of product reliability in the 10-25% range under PBC, compared to the reliability observed under T&M contracts. This finding is robust to numerous alternative specifications, modeling assumptions and estimation methods. Thus our research provides a valuable input into the ongoing policy debate about the effectiveness of performance contracts which are currently being introduced extensively in both the government and the private sectors.