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Incentive Contracts in Serial Stochastic Projects

Author

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  • Tony Chen

    (Department of Information Systems and Operations Management, Michael G. Foster School of Business, University of Washington, Seattle, Washington 98195)

  • Ted Klastorin

    (Department of Information Systems and Operations Management, Michael G. Foster School of Business, University of Washington, Seattle, Washington 98195)

  • Michael R. Wagner

    (Department of Information Systems and Operations Management, Michael G. Foster School of Business, University of Washington, Seattle, Washington 98195)

Abstract

In this paper we propose an incentive payment contract for stochastic projects defined by a series of stages or tasks that are outsourced to independent subcontractors. Projects defined by sequentially completed independent stages are common in new product development and other high-risk projects. Our goal is to maximize the client’s expected discounted profit. Our proposed contract reflects the convex time-cost trade-off that is well known in the project scheduling literature. We show that this type of contract dominates a fixed price contract with respect to expected client’s profit and schedule performance, regardless of payment timing considerations. Using a piecewise linear approximation, we show that our contract is a generalization of an incentive/disincentive contract that is frequently used in practice. We show how our contract can be used to find the optimal due date and penalties/bonuses in an incentive/disincentive contract. We compare this contract with several variations and discuss implications for both the client and subcontractors.

Suggested Citation

  • Tony Chen & Ted Klastorin & Michael R. Wagner, 2015. "Incentive Contracts in Serial Stochastic Projects," Manufacturing & Service Operations Management, INFORMS, vol. 17(3), pages 290-301, July.
    • Handle: RePEc:inm:ormsom:v:17:y:2015:i:3:p:290-301
    DOI: 10.1287/msom.2015.0528
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    References listed on IDEAS

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    Cited by:

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    3. Bai, Jiaru & So, Kut C. & Tang, Christopher, 2016. "A queueing model for managing small projects under uncertainties," European Journal of Operational Research, Elsevier, vol. 253(3), pages 777-790.
    4. Shivam Gupta & Anupam Agrawal & Jennifer K. Ryan, 2023. "Agile contracting: Managing incentives under uncertain needs," Production and Operations Management, Production and Operations Management Society, vol. 32(3), pages 972-988, March.
    5. Shi Chen & Hau Lee, 2017. "Incentive Alignment and Coordination of Project Supply Chains," Management Science, INFORMS, vol. 63(4), pages 1011-1025, April.
    6. Zhihua Chen & Yanfei Lan & Ruiqing Zhao & Changjing Shang, 2019. "Deadline-based incentive contracts in project management with cost salience," Fuzzy Optimization and Decision Making, Springer, vol. 18(4), pages 451-473, December.
    7. Shi Chen & Ted Klastorin & Michael R. Wagner, 2021. "Designing practical coordinating contracts in decentralized projects," Naval Research Logistics (NRL), John Wiley & Sons, vol. 68(2), pages 183-198, March.
    8. Ju Myung Song & Yao Zhao & Xin Xu, 2021. "Incentives and Gaming in Collaborative Projects Under Risk-Sharing Partnerships," Manufacturing & Service Operations Management, INFORMS, vol. 23(2), pages 453-470, March.
    9. Stylianos Kavadias & Karl T. Ulrich, 2020. "Innovation and New Product Development: Reflections and Insights from the Research Published in the First 20 Years of Manufacturing & Service Operations Management," Manufacturing & Service Operations Management, INFORMS, vol. 22(1), pages 84-92, January.
    10. Jinjin Liu & Hua Ke & Yuan Gao, 2022. "Manufacturer’s R &D cooperation contract: linear fee or revenue-sharing payment in a low-carbon supply chain," Annals of Operations Research, Springer, vol. 318(1), pages 323-355, November.
    11. Morvarid Rahmani & Guillaume Roels & Uday S. Karmarkar, 2017. "Collaborative Work Dynamics in Projects with Co‐Production," Production and Operations Management, Production and Operations Management Society, vol. 26(4), pages 686-703, April.
    12. Yu, Xinning & Lan, Yanfei & Zhao, Ruiqing, 2021. "Strategic green technology innovation in a two-stage alliance: Vertical collaboration or co-development?," Omega, Elsevier, vol. 98(C).
    13. Kerkhove, L.P. & Vanhoucke, M., 2016. "Incentive contract design for projects: The owner׳s perspective," Omega, Elsevier, vol. 62(C), pages 93-114.

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