Optimal Procurement Mechanisms for Assembly

Assembly supply chains are ubiquitous in manufacturing. Firms such as Toyota, Apple, and Boeing procure various components from different suppliers to assemble automobiles, smartphones, and airplanes. Such large original equipment manufacturers (OEMs) typically possess dominant market power and can extract most profits out of suppliers. On the other hand, suppliers can keep some profits due to having more accurate information regarding their own costs. The classic contracting research reveals that an OEM’s optimal procurement mechanism facing a supplier with private cost information is a screening mechanism where the OEM offers a menu of quantity-payment contracts (each consisting of a transaction quantity and a corresponding payment) for the supplier to choose from. The mechanism earns its name because when the supplier chooses the most profitable contract from the menu, the OEM can deduce the supplier’s implied cost, effectively screening the supplier of its private information.

Applying this classic screening mechanism to an assembly setting may initially seem trivial: the OEM only needs to offer a menu of quantity-payment contracts to each supplier. However, a close inspection immediately brings an issue to light: with each supplier choosing its most profitable contract, different suppliers may choose contracts of different transaction quantities, yet the OEM always needs proportional quantities of components for assembly. The potentially mismatched quantities clearly indicate that simple quantity-payment screening of each supplier is unlikely to be an optimal mechanism for assembly.

In our M&SOM paper (Hu and Qi 2018), we analyze procurement mechanisms in assembly supply chain and solve for the optimal mechanism. We find that an optimal mechanism must always coordinate purchase quantities from suppliers (lead to proportional purchase quantities), and when implemented as a quantity-payment screening mechanism must involve contingent contracts. This means that even after a supplier chooses a contract from a menu, the eventual transaction and payment terms are still undetermined and will depend on all other suppliers’ choices. Such a mechanism is much more complex than the classic quantity-payment screening mechanism for a single supplier and, more crucially, not very practical: How many suppliers are willing to sign contracts with undetermined terms?

Fortunately, we find that optimal procurement mechanisms for assembly can be implemented as a screening mechanism with non-contingent two-part tariff contracts. A two-part tariff contract refers to one that specifies a per-unit wholesale price as well as a lump-sum payment to the supplier, while allowing the buyer to choose any purchase quantity. In such an implementation, the OEM offers each supplier a menu of two-part tariff contracts, and each supplier chooses a wholesale-price-lump-sum-payment pair. Notably these terms are determined and do not depend on other suppliers’ choices. The reason why non-contingent two-part tariff contracts can implement optimal procurement mechanisms is that the contracts only specify pricing terms with suppliers, and the OEM is free to make coordinated purchase quantity decisions after learning all suppliers’ effective costs, eliminating the need for contingent contract terms to coordinate purchase quantities. It is worth noting that a two-part tariff contract is approximately equivalent to a tiered-pricing contract which specifies different unit prices in a number of quantity tiers, and gives the buyer the flexibility to choose the purchase quantity. The finding that such commonly used contracts can be used to implement optimal procurement mechanisms for assembly thus carries significant practical implications. In fact, we interviewed a high-level procurement executive at a major American pharmaceutical and consumer packaged goods manufacturer, who confirmed that he had used tiered-pricing contracts to manage his assembly supply chains, and was excited to learn that he could confidently optimize within this contract format without suspecting that another contract format might be superior.

Contracting with multiple suppliers naturally gives rise to another issue: contracting timing. The OEM may contract with all suppliers at the same time, or strategically contract with one supplier and learn its cost information before utilizing the information for an advantage in contracting with another supplier. Should OEMs contract with suppliers simultaneously or sequentially? Intuitively, sequential contracting seems to be the clear winner as the OEM has access to additional information during the contracting process. Nevertheless, the economic theory of mechanism design by informed principals indicates otherwise, stating that the OEM’s additional information is generally a liability as the OEM needs to make costly efforts to credibly signal the information to suppliers. Notwithstanding either the intuition or the theory, we find that in our case the OEM and all suppliers are indifferent between simultaneous and sequential contracting because they generate identical profits for everyone. This result is somewhat surprising and highlights the uniqueness of the problem. It means that in assembly supply chains befitting our model, managers need not strategize contracting sequences, but rather should focus on achieving the best pricing with each supplier.

Reference           

Hu B, Qi A (2018) Optimal procurement mechanisms for assembly. Manufacturing Service Operations Management 20(4):655–666. 

Comments