Valuation of performance-based contracts for capital equipment: A stochastic programming approach

ABSTRACT

Evaluating performance-based contracts (PBCs) for capital equipment can be a challenge because it is difficult to map service-level improvements to operational availability. This article considers scenario-based stochastic programming models for the evaluation of PBC alternatives for capital equipment consisting of a single-component system. In particular, PBC alternatives are evaluated for robustness under uncertainty in mean time between failures and mean downtime. The models measure expected deviation of implied contract operational availability and realized operational availability, and robustness is measured by the extent of improvement in service quality under a budget constraint. Optimal contract service levels are also computed that can be compared to service levels offered in a contract alternative. Value at risk (VaR) and conditional value at risk (CVaR) values for contracts are generated to gain insight into the readiness risk of contracts.

Acknowledgment

We would like to thank Tim Jefferis from the United Kingdom's Ministry of Defence for his support and for proposing the initial idea for this article.

Additional information

Notes on contributors

Mohammadreza Sharifi

Mohammadreza Sharifi is a Ph.D. candidate at the Centre of Maintenance Optimization and Reliability Engineering (C-MORE) in the Department of Mechanical and Industrial Engineering at the University of Toronto where he is supervised by Professor Roy H. Kwon. He holds a B.Sc. in industrial engineering from Sharif University in Iran and an MA.Sc. in operations research from the Sauder School of Business at the University of British Columbia, Vancouver, Canada.

Roy H. Kwon

Roy H. Kwon is an associate professor in the Department of Mechanical and Industrial Engineering at the University of Toronto. He obtained his Ph.D. in operations research at the University of Pennsylvania. His primary focus is in the field of mathematical optimization with applications in financial engineering, risk management, and operations management. He is also a member of the faculty in the Mathematical Finance Program (MMF) at the University of Toronto. Dr. Kwon has extensive consulting and collaboration with industry in the use of financial optimization.

Andrew K. S. Jardine

Andrew K. S. Jardine is Professor Emeritus and director of the Centre for Maintenance Optimization and Reliability Engineering at the University of Toronto. He obtained his Ph.D. in engineering production from the University of Birmingham, England. Professor Jardine's teaching and research focuses on the optimization of engineering asset management decisions. He is a Fellow of IIE and the Canadian Academy of Engineering.