Strategic Reliability Investments in Multi-Indenture Supply Chains

In recent years, performance-based contracting (PBC) has emerged as an e¤ective means to manage relationships with suppliers who provide services for maintenances of high-valued products. It has been documented that PBC promotes improvement of product reliability, a key determinant of product performance and overall cost. However, nontrivial challenges exist in a typical supply chain where multiple suppliers design and provide services for distinct subsystems and where product reliability is largely set in an early product development phase. We identify a source of ine¢ ciency in this environment that leads the suppliers to underinvest in reliability. Using PBC neutralizes such ine¢ ciency, but unexpectedly, it results in an overinvestment in reliability. Interestingly, long-term supply chain cost is reduced when PBC is combined with cost-sharing contracts, counter to the common belief that …xed-price contracts are more e¤ective in reducing costs. Our …ndings suggest that optimal contracts critically depend on complexity of a supply chain structure.