Designing practical coordinating contracts in decentralized projects

Abstract

AbstractManaging decentralized projects (DPs) effectively is a critical issue today as projects have become increasingly complex, costly, and strategically important (especially IT and new product development projects). In this article, we consider a DP that is composed of n serial stages with stochastic durations; the project is planned, organized, and funded by a client organization that contracts the work at each stage to independent contractors. Following previous research and practice, we assume that the client and contractors incur time‐dependent costs (including indirect/overhead costs), resource‐related direct costs, and incentive payments. We initially propose a general linear time‐based incentive contract and show that a simplified version of this contract can indeed coordinate a DP when discounting is not considered. The proposed contract sets the penalty due date to the start of each contractor's stage, and the optimal penalty cost rate is set equal to the client's overhead/indirect cost; it actually implies that the contractor is required to compensate for the client's indirect/overhead cost for the duration of the stage. This greatly simplifies the design and implementation of an optimal (coordinating) contract in a DP as the coordinating contract does not require the contractor's private cost information. When discounting is present, we show that a nonlinear contract coordinates the project and provide numerical evidence for when the linear time‐based incentive contract is a good approximation.