Production, Manufacturing and LogisticsContracting with an urgent supplier under cost information asymmetry
Introduction
We study a supplier–manufacturer contract setting problem motivated by a real telecommunications firm, which has more than a 60% share in the competitive mainland Chinese mobile market. The operator implements a centralized procurement policy to procure major IT equipment for its provincial subsidiaries. The prime suppliers are multi-national companies which dominate the equipment market in terms of technology, quality and performance, and are treated as “strategic suppliers” by the operator. As the strategic suppliers usually produce equipment on a “Make-To-Order” (MTO) basis, their lead time is inevitably long for urgent orders.
On the other hand, there are local suppliers who are aggressively penetrating this niche market. These local suppliers offer lower price and better localized service. Especially, they are willing to put in additional effort to meet urgent needs, by temporarily increasing their production capacity, selecting the fastest possible transportation mode, etc. Therefore, the operator regards them as “backups”. When strategic suppliers cannot fulfill demand sufficiently, the operator turns to these local suppliers.
One difficulty of managing local suppliers is the asymmetry of information on production cost. As local suppliers claim that they have to put in additional effort to meet urgent demands, it is difficult for the operator to estimate their production costs. Consequently, the operator cannot determine the unit wholesale price on the basis of a supplier’s real cost; it can determine the price only on the basis of its own previous purchases. The operator has observed that local suppliers tend to deliver the products as late as possible, and suspects that the price-only contract being used is not efficient enough to induce the suppliers to adhere to delivery schedules. Therefore, the operator is also interested in ascertaining whether there exists a more efficient contract type.
We regard the operator as a “manufacturer” and its subsidiaries as “customers” who buy the products. We observe that this problem exists in many industries in China, where, quite often, a few large State Owned Enterprises (SOEs) dominate the market but have to rely on overseas suppliers for major modules, while local suppliers rely on these manufacturers for deals.
Therefore, we consider a manufacturer–supplier contract setting problem where the manufacturer procures a certain quantity of products from overseas supplier before the selling period, according to anticipated demand. When the actual demand exceeds the procurement, the manufacturer places urgent orders with the local supplier, whom we call the urgent supplier. We study two types of contracts in this paper. One is the price-only contract, and the other is a general contract menu stipulating (L, T), where L is the lead time quotation and T is the corresponding transfer payment. It is a common practice to set a price-only contract with the local supplier, under which the supplier agrees to deliver the required product by a set deadline, at a certain unit price, which is largely determined by the manufacturer. We investigate the efficiency of this contract, and its optimal price. We are especially interested in the (L, T) optimal contract menu because the revelation principle of Myerson (1979) states that there is an optimal contract menu under which the party will truthfully share its private information with others. Hence the manufacturer needs to consider only contract menus that give the urgent supplier no incentive to hide its cost information.
Our main findings are as follows:
- (1)
The manufacturer prefers to invite the local supplier into the game since it can serve not only as a recourse for meeting urgent demand, but also as a potential competitor of the prime supplier. Moreover, we observe that the more efficient the contract type is, the higher the profit the manufacturer can earn. In contrast, the prime supplier is disadvantaged by the efficiency of the contract.
- (2)
Under the price-only contract, the urgent supplier tries to minimize its cost by delaying delivery to the greatest extent possible, and the contract is not efficient to reveal the local supplier’s true cost information. In contrast, under the (L, T) contract, the local supplier would share its cost information truthfully, enabling the manufacturer to earn higher profit. We further prove that the manufacturer needs to adopt a threshold policy for its strategy in sourcing from the local supplier under both contracts.
- (3)
By numerical studies, we observe that the manufacturer is more likely to adopt the (L, T) contract when the urgent supplier’s quality is higher, when the urgent supplier has higher chance to be of the low cost type, or when compensation to end customers for inferior modules or delayed delivery is high. These observations can assist the manufacturer to determine whether it is worth introducing the (L, T) contract, if there are costs (for example, administration costs) attached to it.
Now we briefly discuss the related literature. The first body of research related to our paper is the selection of, and procurement from, suppliers. In general, this study focuses on evaluating suppliers’ different characteristics (e.g., production capacity, product quality and cost structure) and making the right supplier selection, replenishment and contract setting decisions thereafter. Chen et al. (2001) analyzed optimal supplier selection, replenishment and inspection strategies, when the product quality and repairing costs of suppliers were different. Sethi et al. (2003) studied how the manufacturer replenishes from two suppliers with different production costs and lead times, in order to maximize its total profit. Federgruen and Nan (2008) determined the optimal set of suppliers, and the optimal order quantity from each supplier, with a random yield factor. These papers investigate the buyer’s decision-making for optimal sourcing and replenishment from suppliers with similar characteristics, under complete information. In our paper, the prime supplier has better performance while the urgent supplier has higher flexibility in delivery time. Since the urgent supplier has private cost information, we study the contract setting problem and analyze the interaction between suppliers and the manufacturer in a Stackelberg game setting.
The second body of related research covers supply chain contracting under stochastic demand with complete information. Tsay (1999) focused on supply chain coordination with quantity flexibility contracts and Barnes-Schuster et al. (2002) proposed option contracts and developed sufficient conditions on cost parameters to achieve channel coordination. Cachon and Lariviere (2005) demonstrated that revenue sharing coordinated a supply chain even with price dependent demand. Chen and Xiao (2009) investigated models of coordination of a supply chain consisting of one manufacturer, one dominant retailer and multiple fringe retailers with demand disruption. A comprehensive survey of literature is provided by Cachon (2003). Our paper studies contract setting and replenishment decisions under private cost information, and thus differs from the above papers.
The salient feature of the third stream is analyzing how asymmetric information influences the performance of each party in various supply chain settings. Özer and Wei, 2006, Ha and Tong, 2008, Fu and Zhu, 2009 studied contract issues under asymmetric demand information in different settings. Ha, 2001, Corbett et al., 2004, Sucky, 2006 considered a supplier–buyer channel where the buyer had private cost information. Cachon and Zhang (2006) investigated procurement strategies in a queuing framework where the supplier had private capacity cost information. Yang et al. (2009) analyzed the manufacturer’s optimal procurement mechanism design problem when the supplier was privileged with the information about supply disruptions. Wang et al. (2009) studied the performance of an upstream manufacturer with private production cost information where the retailer faced price dependent deterministic demand, under four contract formats. Our paper also investigates the contract setting problem where the supplier has private cost information, as in Cachon and Zhang, 2006, Yang et al., 2009, Wang et al., 2009. Our paper differs from Yang et al., 2009, Wang et al., 2009 as we consider a supply chain with two suppliers and one manufacturer, when the final demand is stochastic, and the production cost is lead time dependent. Compared with Cachon and Zhang (2006), our problem is under a single period setting, while theirs is a queueing model. The suppliers in our paper have different leverages, and we consider replenishment decision, instead of the capacity design problem.
The analytical underpinnings of our paper are provided by the principal-agent models originated from Economics. Ross (1973) provided an introduction to the principal-agency issue, and Mas-Colell et al. (1995) described two main variations (hidden action and hidden information scenarios) of the basic model. In this paper, we investigate the hidden-information scenario and analyze the so-called mechanism design problem.
The remainder of the paper is organized as follows. Section 2 briefly describes the model set up. Section 3 analyzes the manufacturer’s contract setting problem with the local supplier, while Section 4 investigates the overseas supplier’s optimal pricing decision, and compares the performance of each party under different scenarios (without, and with the urgent supplier under either the price-only contract, or (L, T) contract). Section 5 demonstrates how the parameters affect the manufacturer’s profits, by numerical examples. We conclude the paper in Section 6. All proofs are stated in the online supplementary material.
Section snippets
Model description
Consider a manufacturer who sells a product directly to a market where demand D follows a continuous and differentiable distribution function with , and its mean is . The manufacturer procures its key modules from dual sources (the long lead time overseas supplier and the short lead time local supplier).
The module produced by the overseas supplier (S1) is of higher quality and a final product made with this module will be sold at unit price r1. As the lead time is long, the
Stage 2 game: Manufacturer’s replenishment decision
In this section, we answer the following questions: 1. How does the manufacturer perform under the price-only contract? 2. What type of contract can bring the manufacturer higher expected profit? 3. Under different contract types, how does S2 respond?
Stage 1 game: S1’s pricing decision
At this stage, the overseas supplier S1 determines its optimal wholesale price w, considering the possible reaction of the manufacturer and urgent supplier S2. A higher w leads to higher profit margin but fewer orders from the manufacturer. In addition, the nature of the contingent contract type also influences the pricing decision of S1. In this section, we consider three scenarios; Scenarios N, O, and P. In Scenario N, S2 does not participate in the supply chain. In Scenario P, S2 is involved in
Sensitivity analysis
From the analysis in the last section, we recognize that the type of contract with the local supplier will influence the manufacturer’s profit. However, there is a question which remains unanswered: “Under what market conditions has the (L, T) contract higher advantages over the common price-only contract?” The answer to this question can help the manufacturer decide which contract to use, if execution of the optimal contract has costs attached to it. Therefore, we numerically test how the
Conclusion
This paper studies the effects of the presence of a contingent urgent supplier with private cost information on the performance of both the prime supplier and the manufacturer. Contingent contracts of both types, price-only and (L, T), are investigated. The manufacturer’s optimal strategy for sourcing from the urgent supplier follows a -dependent threshold policy under both contracts. We find that right combinations of lead time quotations and transfer payments can induce the urgent supplier to
Acknowledgments
The authors would like to thank the three anonymous referees for their helpful comments and suggestions that greatly improved the presentation of this paper. The authors are grateful to Shilu Tong for his insightful comments on the earlier version of this paper.
This work was partly supported by the National Natural Sciences Foundation of China under Grants NSFC70801029, NSFC70802063, NSFC70672040 and by the Guangdong Natural Science Fund Committee under Grant GNSF 8451027501001466.
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