Reliability or Inventory? Analysis of Product Support Contracts in the Defense Industry

Abstract

In the defense industry, traditional sourcing arrangements for after-sales support of weapons systems (“products”) have centered around physical assets. Typically, the customer, a military service, would pay the supplier of maintenance services in proportion to the resources consumed, such as spare parts, that are needed to maintain the product. In recent years, we have witnessed the emergence of a new service contracting strategy called Performance-based Logistics. Under such a performance-based contract (PBC), the basis of supplier compensation is actual realized uptime of the product. The goal of this paper is to compare the inefficiencies arising under the traditional consumption-based contract (CBC) 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 as well as invests in increasing 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 large portion of the spare product assets. Our analysis advocates usage of PBC in favor of CBC and supports a DoD recommendation for transforming suppliers into total service providers.