Besides many benefits of the outsourcing, the firms are still concerned about the lack of the critical information regarding both the risk levels and actions of their suppliers that are just a few links away. In this paper, we study different contractual mechanisms to deal with such suppliers. More specifically, we consider a dyadic supply chain in which a manufacturer procures from a supplier whose production quantity is subject to disruption risk. The extent of disruption risk is private information for the supplier. Furthermore, to reduce the disruption risk, the supplier can exert a costly process improvement effort that is also unobserved by the manufacturer. Using this setting, we investigate whether the manufacturer should try to influence the supplier's process improvement effort or simply delegate the decision to the supplier. To address this question, we design three different contracts between manufacturer and supplier: Delegated-Effort Contract (DC); Induced-Effort Contract (IC); and, Audited Effort Contract (AC). By offering DC, the manufacturer delegates the process improvement decision to the supplier himself. However, since there is a mismatch between how much manufacturer and supplier benefit from an improvement effort, DC does not always coordinate the supply chain. The manufacturer can rectify this inefficiency either by giving right incentives to the supplier through performance contract (offering IC), or by paying additional cost to audit the supplier's process improvement effort (offering AC). Our results show that the manufacturer can never be better off by offering IC because of high informational rent that the more reliable supplier earns due to manufacturer's inability to observe supplier's actions and the true state of his disruption risks. The manufacturer then trades off inefficiencies caused by delegation against the cost of audit to decide whether to delegate the improvement effort to the supplier or to audit him. Interestingly, we find that, under certain conditions, all the supply chain parties can be better off when the manufacturer audits the supplier.
Group for Research in Decision Analysis