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Abstract

This thesis addresses the design of performance-based contracts in decentralized supply chains when a supplier’s effort is unobservable. The first two essays explore issues in the design of service level agreements (SLAs), a type of performance-based incentive scheme widely used for outsourcing manufacturing and services. We consider a supply chain in which a supplier manages the supply of a durable product for a buyer and the buyer contracts with the supplier on the supplier’s inventory service level. The SLAs are discontinuous incentive schemes with a multi-period review strategy, and the supplier’s performance measure is the ready rate. The first essay investigates the effectiveness of two common types of SLAs: a lump-sum penalty SLA and a linear-penalty SLA. We find that when the supplier can observe the performance history and dynamically adjust the investment in inventory to affect her review period performance, to mitigate the supplier’s incentive for strategic behavior, the penalty should be dependent on the degree of the supplier’s performance deviation from the target. The second essay focuses on the effectiveness of performance measures in SLAs. The problem is similar to that in the first essay, but the supplier can invest in inventory and in lead time. We consider two inventory performance measures: immediate ready rate and time-window ready rate, and find that there exists a unique positive time window such that a ready rate with window induces the first-best investments. Our findings demonstrate the importance of choosing the right performance measure to align a supplier’s incentive. The third essay investigates the design of performance-based volume incentive schemes in the form of allocating business between suppliers when a buyer maximizes his long-run discounted payoff from repeated dual sourcing. We consider both the case where a supplier’s effort cost is proportional to her business volume and the case where the cost is independent of her volume. We find that to induce and maintain suppliers’ competition over time, the optimal scheme depends on each supplier’s current share of business and is generally not a simple rank-order tournament; handicapping the definition of winner can do better than a simple first-past-the-post rule.