Optimal Cost Avoidance Investment and Pricing Strategies for Performance-Based Post-Production Service Contracts

Abstract

Performance-based contracting (PBC) is altering the fundamental relationship between buyers and suppliers engaged in the support of capital-intensive systems such as high-speed rail, defense, and power generation. This relationship is shifting from a traditional transactional-based (return on sales) business approach to a collaborative, performance-based (return on investment) multi-year contractual model. With PBC, the supplier is compensated for system performance rather than for each maintenance, repair, and overhaul (MRO) transaction. PBC success lies in the incentive structure. Under PBC supplier profits, system performance and operator costs are improved when smart investment decisions are made that trade year after year MRO costs for upfront investments that reduce total cost of ownership. This paper develops a decision-theoretic model that determines the optimal contract length and optimal investment and pricing strategies for performance-based, post-production service contracts that simultaneously maximizes the profit to the supplier while satisfying the customer's needs. The model accounts for reliability as a function investment, the average and variance of the cost to perform maintenance tasks, and for customers willingness to pay for a contract depending on its length. Numerical examples illustrate how optimal strategies depend on potential market size, expected cost per failure, and on other parameters of the model.