How incentive alignment along the supply chain fosters incremental innovation: evidence from defence performance-based contracts

Purpose To investigate how providers of product-service bundles design and manage their contracts with upstream suppliers to incentivise incremental innovation for the benefit of their downstream customers, who contract the provider based on performance. Design/methodology/approach An embedded multiple-case study was conducted to examine elements of a European jet fighter’s manufacturing and after-sales supply chain. The embedded cases concern provider contracts with first-tier suppliers of product and service offerings. Data collection involved 21 semi-structured interviews, documents and other secondary data sources. Data analysis was informed by agency theory to assess the effectiveness of contract design and management in delivering incremental innovation and to identify related contracting strategies. Findings We identify four strategies for fostering incremental innovation in contracts between providers and their first-tier suppliers. These include two contract design strategies, i.e. reducing goal incongruence and addressing information asymmetry; and two contract management strategies, i.e. reducing outcome uncertainty and promoting inter-firm integration between providers and sub-suppliers. Practical implications The research offers managerial guidelines regarding how providers can design and manage their tier-one supplier contracts to achieve incremental innovation. These include encouraging early supplier involvement, using focussed KPIs in contracts, and managing product and service-offering suppliers differently. Originality/value The research shows the contingent effect during contract design and management of a sub-supplier’s product vs. service offering, which, in turn, impacts incremental innovation. We also find that using focussed key performance indicators in sub-supplier contracts can be effective in improving product and service quality.