KIM Sang-Hyun, COHEN Morris A., NETESSINE Serguei
INSEAD Working Paper 2011/58/TOM revised version of 2010/62/TOM
In the defence industry, traditional sourcing arrangements for after-sales support of weapons systems (“products”) have centred around physical assets. Typically, the customer, a military service, would pay the supplier of maintenance services in proportion to the resources used (such as spare parts) to maintain the product. In recent years we have witnessed the emergence of a new service contracting strategy called performance-based logistics. Under a performance-based contract (PBC), the basis of supplier compensation is actually realized during uptime of the product. The goal of this paper is to compare the inefficiencies arising under the traditional resource-based contract (RBC) and PBC. In both cases, the customer sets the contract terms, and as a response the supplier sets the base-stock inventory level of spares and invests in improving product reliability. We find that PBC provides stronger incentives for the supplier to invest in reliability improvement, which in turn leads to savings in acquiring and holding spare product assets. Moreover, the efficiency of PBC improves if the supplier owns a larger portion of the spare assets. Our analysis supports the DoD recommendation for moving towards PBC and transforming suppliers into total service providers.