M&SOM Review

Global Sourcing How, What, Why>

Ever-increasing competition in global markets has forced many firms to outsource their non-core operations to focus on their core competencies. While the outsourcing benefits are clear, it may also bring new challenges on how to manage global sourcing. Two practical issues may arise when a buyer tries to assure supply in outsourcing. First, when devising a sourcing strategy, the buyer often does not have perfect information about the supplier’s cost structure; the supplier’s cost structure is highly confidential information because it conveys significant bargaining power when negotiating a contract with a buyer. Second, the suppliers’ actions may not be verifiable or enforceable. In particular, the contracted capacity may not be enforceable for a couple of reasons: First, capacity is a complex decision that involves many factors, including the supplier’s managerial effort; thus, when a supplier fails to deliver the promised quantity, it might be hard to verify whether this is due to underinvestment in effort or reasons beyond the supplier’s control. Second, if the cost of enforcement (e.g., the cost of capacity verification and the cost of a lawsuit) is prohibitively high, contract terms that penalize a dishonest supplier might not be credible. Due to lack of enforcement, the supplier may purposely deviate from the agreed capacity, making capacity investment a noncontractible decision.

The globalization trend has made both of these issues more prominent because of increased length and complexity of supply chains. For example, studies have shown that it is common that in global supply chains, buyers do not have precise information about the cost structure of their suppliers located overseas (Noordewier et al. 1990 and Hortacsu et al. 2009). Moreover, it is known that regulatory institutions and law enforcement are weak in emerging economies, which may give rise to contractibility issues due to higher contract enforcement costs (Antras 2015). The World Bank (2008) provides a comparison of the judicial system’s efficiency in resolving commercial disputes in different countries or regions. The report shows that developing countries are often associated with less efficient judicial systems (e.g., longer wait time, higher litigation fees, and more complex procedures), which present a major obstacle for these countries to attract foreign businesses and investments. According to a Deloitte survey, 70% of executives were extremely or very concerned about suppliers’ compliance risks in emerging markets (Sinha 2014).

Bolandifar, Feng, and Zhang (2016) study a buyer’s supply contracting problem under the presence of the above practical issues. It has been recommended by practitioners that without capacity enforceability, firms may tie their payment to actual accepted delivery, rather than the promised capacity (Pierce 2012). Bolandifar, Feng, and Zhang (2016) show that this recommendation can be quite effective in achieving the same results as when firms can enforce supplier’s capacity investment. That is, a carefully designed payment schedule based on the actual delivery quantity can substitute for contract terms that specify the supplier’s capacity investments.  In particular, under such a solution, the lack of capacity enforcement will not lead to additional profit loss caused by the asymmetric information about the supplier’s cost structure.

More importantly for practice, the authors find that the theoretically optimal contract would reduce to a simple two-part tariff under certain conditions. In other words, a single, linear contract based on the actual delivery quantity (sometimes just a wholesale price contract) could be optimal for the buyer. Even when it is not strictly optimal, extensive numerical analysis suggests that it can still provide near-optimal profit for the buyer. In addition, it has been found that the simple contracts usually increase supply chain profits, implying that these contracts might be desirable from both supply chain members’ standpoints.

How to contract to assure supply under the presence of information and enforcement issues? The research by Bolandifar, Feng, and Zhang (2016) provides a confirmative answer. The findings bode well for managers facing the above practical issues, especially in a global sourcing context: For both ease of implementation and excellent performance, a buyer can simply use a two-part tariff contract (or sometimes just a wholesale price contract) under the presence of cost information asymmetry and contractibility issues. Moreover, the results suggest that the buyer should try all means to reduce the uncertainty about the supplier’s cost structure, which could lead to significant losses both for the buyer and for the supply chain. This is because such uncertainty provides a robust protection of the information rent the buyer has to pay to the supplier; even the complex, optimal contract does not help much in reducing the information rent.

 

References

Antras P (2015) Global Production, Firms, Contracts, and Trade Structure (Princeton University Press, Princeton, NJ).

Bolandifar E, Feng TJ, Zhang F (2016) Simple Contracts to Assure Supply under Non-contractible Capacity and Asymmetric Cost Information. Manufacturing and Service Operations Management. Permalink: https://doi.org/10.1287./msom.2017.0628

Hortacsu A, Martinez-Jerez F, Douglas J (2009) The geography of trade in online transactions: Evidence from eBay and Mercado Libre. American Economic Journal: Microeconomics 1(1):53–74.

Noordewier TG, John G, Nevin J (1990) Performance Outcomes of Purchasing Arrangements in Industrial Buyer-Vendor Relationships. J. of Marketing 54(4):80–93

Pierce F (2012) How to Avoid Contract Trouble in China. (March 15), http://www.supplychaindigital.com/scm/how-avoid-contract-trouble-china.

Sinha S (2014) Creating a Culture of Compliance Across Your Supply Chain. (July 3), https://www.qualitydigest.com/inside/qualityinsider-article/creating-culture-compliance-across-your-supply -chain.html#.

World Bank, The (2008) Doing Business: Comparing Regulation in 181 Economies (World Bank Publications, Washington, DC).

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