Delayed Payments as Performance-based Contracts

Abstract

Performance-based contracting is gaining widespread acceptance in supply chains where moral hazard might prevent either or both supply chain entities from exerting the first-best effort that improves supply chain outcomes. We analyze the use of delayed payments as a performance-based contract when supply chain payoffs are lead time dependent. The buyer's margin depends on lead time which is governed by costly supplier effort. For a cash-constrained supplier, the delayed payment offered by the buyer (principal) raises the possibility of bankruptcy and incentivizes the supplier (agent) to exert effort. We study the optimal balance between moral hazard and bankruptcy risk in the context of a delayed payment contract whose objective is to reduce the lead time from supplier to buyer. Modeling the buyer--supplier interaction as an infinite--horizon principal--agent game, we find that suppliers with high cost of effort are able to use the threat of bankruptcy to extract better payment terms from the buyer. Further, these suppliers also exert less effort than what would be optimal for the supply chain as a whole. We show that a payment structure that involves a bonus payment for timely delivery combined with a delayed payment coordinates the supply chain. This payment structure effectively implies buyer cost-sharing in the supplier's effort, contingent on adequate supplier performance. Our results provide buyers with a roadmap on when and how to implement delayed payments as a function of different supplier parameters such as the cost of operational effort and the wholesale price.