Contract design for risk sharing partnerships in manufacturing

The development of extensive partnerships with suppliers has become a characteristic of manufacturing, particularly in the aircraft and automobile industries. This paper considers the development of appropriate contracts that enable market risks to be shared between the lead manufacturer and the partners. It is shown that it is usually appropriate to have threshold contracts, i.e., contracts where a partner only shares in profits if sales exceed a value determined by risk tolerance and target return. The value of having financial partners as well as manufacturing partners is demonstrated, although it is also shown that financial partner contributions to the project should be limited. We also consider the situation where partners have pre-existing commitments to other projects, perhaps with competitors. The producers sales may be correlated with the partners profits on pre-existing commitments so the impact on contract structure is explored. It is shown that even if a partner had preexisting commitments whose profit is positively correlated with product sales then it is often beneficial to use such a partner.

► We look at contracts between an aircraft manufacturer and its suppliers/partners. ► Contracts are used to share risks by appropriate payment structure. ► In optimal contracts a partner shares profits only when sales exceed a target (threshold contracts). ► Rather than a straight loan, financial partners using threshold contracts would be preferable. ► When profitability of preexisting contracts is correlated simple threshold contracts may not be optimal.