Performance-based contract design under cost uncertainty: A scenario-based bilevel programming approach

ABSTRACT This article considers a principal agent model for structuring a performance-based contract in the presence of fixed cost and cost-plus contracts. A scenario-based bilevel programming approach is considered to determine the values of key contract parameters. Additionally, the risk of cost uncertainty is considered in the model in the form of conditional value at risk (CVaR). The incorporation of risk of cost uncertainty can mitigate the impact of extreme events in the tail of the customer's total cost distribution. The numerical results find that at higher risk aversion levels, the customer is willing to pay more to the supplier and at the same time accept a smaller percentage of the shared cost between the supplier and the customer, which indicates the shift of the risk to the supplier. Although the customer is paying more in higher risk aversion levels, less cost is incurred in cases of realization of extreme events compared to the lower risk aversion levels. At lower risk aversion levels, the customer sets a smaller value of incentives for the supplier.