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

Author

Listed:
  • Jose A. Guajardo

    (The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104)

  • Morris A. Cohen

    (The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104)

  • Sang-Hyun Kim

    (Yale School of Management, Yale University, New Haven, Connecticut 06511)

  • Serguei Netessine

    (INSEAD, 77305 Fontainebleau, France)

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. This paper was accepted by Martin Lariviere, operations management.

Suggested Citation

  • Jose A. Guajardo & Morris A. Cohen & Sang-Hyun Kim & Serguei Netessine, 2012. "Impact of Performance-Based Contracting on Product Reliability: An Empirical Analysis," Management Science, INFORMS, vol. 58(5), pages 961-979, May.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:5:p:961-979
    DOI: 10.1287/mnsc.1110.1465
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