Fostering incremental and radical innovation through performance-based contracting in buyer-supplier relationships

Purpose
While anecdotal evidence suggests that performance-based contracts (PBCs) may foster innovation in buyer-supplier relationships, our understanding of the underlying mechanisms is limited to date. This study draws on transaction cost economics and agency theory to develop a theoretical model that explains how PBCs may lead to innovation.

Design/methodology/approach
Using data on 106 inter-organizational relationships from the Dutch maintenance industry, we investigate how the two main features of PBCs—low term specificity and performance-based rewards—affect incremental and radical innovation.

Findings
We find that term specificity has an inverse-U-shaped effect on incremental innovation and a non-significant negative effect on radical innovation. Furthermore, pay-for-performance has a stronger positive effect on radical innovation than on incremental innovation. Our findings suggest that in pursuit of incremental innovation, organizations should draft contracts with low, but not too low, term specificity and incorporate performance-based rewards. Radical innovation may be achieved by rewarding suppliers for their performance only.

Originality/value
Our findings suggest that in pursuit of incremental innovation, organizations should draft contracts with low, but not too low, term specificity and incorporate performance-based rewards. Radical innovation requires rewarding suppliers for their performance only.