Designing service level agreements for inventory management

Service level agreements (SLAs) are widely employed forms of performance‐based contracts in operations management. They compare performance during a period against a contracted service level and penalize outcomes exceeding some allowed deviation. SLAs have a number of design characteristics that need careful tuning to ensure that incentives are properly aligned. However, there is little theoretical research in this area. Using an example of an SLA for outsourcing inventory management, we make a number of recommendations. First it is preferable, if possible, that penalties be proportional to the underperformance rather than lump‐sum ones. This goes a long way towards mitigating strategic (“gaming”) behavior by the supplier. Second, it might be thought that giving “bonuses for good performance” rather than “penalties for bad performance” are essentially identical apart from the former being a more positive approach to management. This turns out to be incorrect in the case of large percentage service rate targets and that penalties will normally be preferred by the buying firm. Third, in order not to incorrectly penalize underperformance resulting purely from “noise” rather than supplier efforts, management might think it best to make allowed deviations from the target generous. Again intuition is not a helpful guide here: for proportional penalties, acceptable performance deviations should be close to the target. Although these results come from a particular inventory application, it is likely that the lessons are applicable to SLAs in general.