Reliability or Inventory? Contracting Strategies for After-Sales Product Support

Traditional sourcing arrangements for after-sales support of capital-intensive products such as airplanes, weapons systems, and manufacturing equipment have centered around physical assets. Typically, customers would pay the supplier of maintenance and repair services (usually the product manufacturer) for the resources, such as spare parts, that were needed to maintain the products. 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 uptime (or availability) of the product. PBL implementations are now mandated by the Department of Defense for all new system acquisition programs. The goal of this paper is to compare the ine¢ ciencies arising under the traditional (pre-PBL or material contract) and the PBL contract. In both cases, the customer (principal) sets the contract terms, and as a response, the supplier sets the base-stock inventory level of spare parts as well as invests in increasing product reliability. We …nd that, in a majority of situations, both contracts result in suboptimal supply chain performance manifested by low product reliability and high inventory of spares (relative to the …rst-best solution). However, the PBL contract provides stronger incentives to invest in reliability improvements than does the material contract. Moreover, the e¢ ciency of the PBL contract improves (i.e., inventory decreases and reliability increases) if the supplier owns a larger portion of the spare assets. In particular, under a PBL contract when the supplier owns all spare assets, the supply chain becomes coordinated. 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. Email: [email protected], [email protected], [email protected]