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

Abstract

Using a proprietary data set provided by a major manufacturer of aircraft engines, we empirically investigate how product reliability is impacted by the 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 of PBC on product reliability. 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 taken into account. Our results are consistent with two mechanisms for reliability improvement under PBC: more frequent scheduled maintenance and better care performed in each maintenance event. AbstractUsing 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.2

Exploiting Big Data in Logistics Risk Assessment via Bayesian Nonparametrics

“…To accommodate the multimodal feature in the empirical transport risk distribution, we apply a state-of-art Bayesian statistics tool -the BNP mixture model. To the best of our knowledge, no prior work has used related techniques in empirical OM, which so far predominantly applies frequentist statistics, such as OLS and maximum likelihood estimation (MLE) (see, e.g., Deshpande and Arikan (2012), Guajardo et al (2012) and the references therein).…”

Contracting in Medical Equipment Maintenance Services: An Empirical Investigation

“…To the best of our knowledge, Guajardo et al (2012) is the only paper that empirically explores the performance of maintenance service contracts. The setup of our respective works differ along two dimensions.…”

“…First, the contracts analyzed are of a different nature. Guajardo et al (2012) focus on performance-based contracts (versus basic plans), which are common in aerospace and defense industries, where equipment owners are typically very large entities. In contrast, we focus on full-protection plans (versus we analyze failure rate as well, but also study service costs (onsite visits, labor hours, and spares cost) and usage rates (the latter on a smaller set of data).…”

Reliability optimization for series systems under uncertain component failure rates in the design phase

“…Different types of service contracts are mentioned in Cohen et al (2006), among which performance-based contracts (PBCs). According to Guajardo et al (2012), "Performance-based contracting compensates the supplier based on the same outcome that the customer cares about (i.e., product utilization), and hence the supplier is motivated to increase product performance, associated with metrics such as product reliability and availability". Therefore PBCs are a certain type of service contracts, in which system performance translates into financial bonuses and penalties (Selviaridis and Wynstra, 2015).…”