Incentives in Multi-Indenture Service Supply Chains

In recent years, performance-based contracting (PBC) has emerged as an e¤ective means to align the incentives of the …rms engaged in after-sales repair and maintenance services of highvalued and customized products, such as industrial equipment and aircraft. In particular, PBC has proved to promote improvement of product reliability, an important determinant of product performance. However, idiosyncratic features of the aftermarket create nontrivial challenges for PBC implementation. Namely, a typical supply chain has a multi-indenture structure, in which multiple suppliers design and maintain distinct subsystems. Additionally, product reliability is often determined in an early design stage, when signi…cant operational uncertainty exists. In this paper we propose a game-theoretic model that captures the dynamics arising in this environment. We identify a negative externality among the suppliers that results in an overall underinvestment in reliability. Using PBC neutralizes such ine¢ ciency, but unexpectedly, it leads to an overinvestment in reliability. Interestingly, we …nd that free riding among the suppliers mitigates the overinvestment incentives. We also identify the situations where committing to contract terms before uncertainty is resolved results in a lower supply chain cost than achieved by postponing the decisions, thereby contradicting the accepted maxim that ‡exibility is always valuable. 1 Introduction and Related Literature For …rms designing and selling high-valued and customized products that generate continued services over a long time horizon— products such as industrial machinery, communication/computing equipment, and aircraft— after-sales support is not an afterthought; instead, it is a main source of revenue stream. For example, GE Aviation, one of the major aircraft engine providers, forecasted in 2009 that 75% of its $85 billion in revenue would come from after-sales services such as spare parts sales and repairs, up from 65% in 2007 (Glader 2009). In fact, it is a common industry practice that …rms sell their products below margin with the intention of recouping the losses from the initial sales with the revenue from the product support services, which typically continue throughout the