Production, Manufacturing, Transportation and Logistics
Value of audit for supply chains with hidden action and information

https://doi.org/10.1016/j.ejor.2020.02.024Get rights and content

Highlights

  • Value of audit for a buyer when contracting with a supplier is studied.

  • Supplier’s process improvement and reliability information are hidden.

  • Not only the buyer but also the supplier can strictly benefit from an audit.

  • Auditing supplier action reduces agency cost related to supplier hidden information.

Abstract

Outsourcing can provide firms with a competitive advantage by realizing the benefits of suppliers’ low labor, better quality and improved innovation. Yet, the supply chain managers have several concerns about outsourcing which are mainly due to lack of critical information regarding the actions of their suppliers. In this paper, we study the effectiveness of auditing the supplier’s hidden actions for the buyer (principal) when the supplier (agent) is privately informed about the extent of the supply risk. In order to accomplish this, we first extend the standard principal-agent model by considering a case in which the agent’s hidden action affects the extent of information asymmetry between principal and agent. By comparing the agency costs associated with the optimal menu of contracts with and without audit, we then completely characterize the value of audit from the perspectives of both buyer and supplier as well as total supply chain. First, the analysis of value of audit from the buyer’s perspective shows that the buyer can strictly benefit from auditing the supplier’s actions. Second, we find that not only the buyer but also the supplier can strictly benefit from an audit. Third, the audit enables the buyer to customize her contract offerings based on the reliability of the supplier. Finally, by analyzing the impact of problem parameters on the value of the audit, we identify the conditions under which an audit would be beneficial for individual supply chain parties as well as the overall supply chain.

Introduction

Globalization leveled the playing field for the supply chains long ago but observing the supplier’s actions in distant locations still remains significant challenge for many companies. After multiple incidences including different Boeing 787s emergency landings due to on-board fires, on January 16, 2013, the Federal Aviation Administration (FAA) issued an emergency directive ordering all US-based airlines to ground their Boeing 787s until further notice. Further investigations [NY Times, 26 January 2013] reveal that the electrical fires were caused by Lithium-Ion batteries whose production was subcontracted by Thales, the French company responsible for the 787’ s electrical systems, to a tier-2 supplier in Asia, which was also approved by Boeing. The groundings cost Boeing an estimated $600 million USD, halted deliveries and forced some airlines to lease alternative airplanes. Boeing may have financial resources to recover from this but such incidences would be detrimental for many companies, particularly those that are aggravated by reduced visibility regarding both the true risk and actions of suppliers that are just a few links away in the supply chain. Indeed, surveys suggest that more than 40% of companies lack this visibility, even into their tier-1 suppliers, and the percentage increases to 75% for tier-2 suppliers [Industry Week, December 2009]. This information asymmetry can be the result of insufficient due diligence on the part of the buyer, or the result of suppliers not taking certain actions (e.g., skipping a certain testing process as in the Boeing case) without informing the buyer. Such increased information asymmetry due to a lack of control is also one of the primary reasons behind problems in IT system outsourcing [Forbes, 2016] as well as the toys, textiles and electronics industries [USA Today, October 2008]. In another study that surveyed high-ranking supply chain executives across the United States (Rogers, 2009), the lack of control over key suppliers stands out as one of the greatest obstacles in improving supply-chain risk management at their companies. These cases also indicate that a lack of control and supply visibility (or lack thereof) not only creates supply chain-related performance shortfalls, but also have had negative effects on companies’ financial performance within the past five years (Hendricks & Singhal, 2005). The main goal of this paper, therefore, is to shed light on the issues caused by the lack of control and visibility regarding the upstream supplier’s actions and to explore the various means with which the resulting adverse effects can be mitigated.

As showcased by the above cases, a particularly important issue that faces a downstream buyer is to find out how to incentivize suppliers to take the costly actions to improve the reliability of their processes in the presence of information asymmetry. Numerous approaches with varying degrees of control and visibility have been proposed in both practitioner and academic circles (Dyer, Cho, & Chu, 1998). One common approach in this case is to use a performance-based contract. This has the benefit of minimizing the costs and maximizing the bargaining power for the sake of buyers. Another approach is to audit the actions of the supplier throughout every phase of the production process. The second approach provides the buyers with more transparency into the actions of their suppliers, but at the same time, makes it more costly for them to establish and, more importantly, maintain such a close relationship with their suppliers. There is some variation in the adoption of these mechanisms among the supply chain companies (Spekman, Kamauff, & Myhr, 1998). Even the same company may change its strategy over the time. For example, consider the case of Apple, which to a large extent, owns its success to its extensive contract-based outsourcing program [NY Times, 21 January 2012]. However, as indicated in its 2019 report [Apple Inc., 2019], Apple seems to increase its degree of control over its suppliers by implementing a very strong auditing program. In just 2018 alone, Apple completed 770 managed supplier assessments covering manufacturing facilities, logistics and repair centers, and contact center facilities. Not only the users of contract-based buyers like Apple but also OEMs that run extensive supplier networks have increased their auditing efforts in order to preempt the publicity smear due to possible noncompliance of their suppliers. For example, an extensive audit program undertaken by Toyota after having to recall around 8 million vehicles due to malfunctioning gas pedals between 2009 and 2010 uncovered another covert action incidence for one of Toyota’s component suppliers [see Bloomberg Business Week report, Kitamura, Ohnsman, & Hagiwara, October 2010].

Motivated by this variation, in this paper, we study the value of audit by comparing the following two mechanisms in the presence of hidden information, the extent of which is affected by the hidden action of the supplier: (i) in the first one, the buyer incentivizes the supplier to take a particular action by offering a performance-based contract (hereafter referred to as “Induced-Effort (IE) contract”); and; (ii) in the second one, the buyer incurs a cost to audit the supplier’s hidden action (hereafter referred to as “Audited-Effort (AE) contract”). By comparing these two settings, our aim is to study the following research questions:

Research Question 1: What is the value of audit in this context for the buyer, the supplier and the total supply chain?

Research Question 2: How do the problem parameters (i.e., supplier’s hidden information and cost of hidden action) affect the value of audit for each supply chain party and total supply chain?

This paper contributes to the literature in two ways. First one is methodological in nature. It is commonly accepted in the principal-agent literature that under the standard setting (i.e., both principal and agent are risk-neutral, and the agent is not protected by limited liability constraints) the moral hazard constraints have no impact on the principal’s payoff (see Laffont, Martimort, 2002, Laffont, Tirole, 1993 and the citations therein). This implies that auditing the agent’s hidden action does not generate any value for the principal. This paper adds to this result a caveat. Specifically, we show that if the hidden actions exerted by the agent affects the degree of information asymmetry between principal and agent, then observing hidden action of the agent can strictly increase the principal’s payoff.

This has significant implications for supply chains that are subject to disruption risk, the extent of which can be affected by the hidden actions taken by the upstream supplier. This constitutes our second contribution. Applying our result to the supply chain setting, we completely characterize the value of auditing the hidden action of the upstream supplier from the perspective of the downstream buyer as well as the total supply chain and show when it can be a win-win strategy for all parties involved.

The remainder of the paper is structured as follows: first, we review the existing relevant literature in Section 2. The modeling approach and assumptions will be discussed in Section 3. In section Section 4, we characterize the optimal contract under full information scenario. The optimal Induced-Effort and Audited-Effort contracts under information asymmetry are characterized in Sections 5 and 6, respectively. In Section 7, we identify the value of audit for the buyer and supplier as well as whole channel. Finally, Section 8 concludes the paper.

Section snippets

Literature review

Our paper is related to two streams of research in operations management. The first one focuses on modeling improvement decisions of supply chain firms. The second stream relates to contract design under supply disruption. In what follows, we review each stream and relate them to our work.

The papers in the first stream vary in terms of whether the decision taken by the firm improves the quality of the product (Babich, Tang, 2012, Baiman, Fischer, Rajan, 2000, Balachandran, Radhakrishnan, 2005,

Model framework

Consider a stylized two-level supply chain model with a buyer (hereinafter referred to as “she”) and a risky supplier (referred to as “he”). At the downstream level, the buyer faces a unit demand D and earns $b per unit sold in the market. To satisfy her demand, she needs to procure from a supplier whose production cost is $c per unit. In order to focus on the supply-side risks, we assume that the demand is known at the time of the contract and, without loss of generality, we normalize it to be

First-best solution

As a benchmark, in this section, we assume that the supplier’s reliability θ is known and his choice of process improvement eθ is observable by the buyer. Given the contract (Uθ, Xθ, ξθ) offered by the buyer, the supplier takes action eθfb, where superscript ``fb″ indicates the first-best level of effort. Note that by observing both the supplier’s reliability type and decision, the buyer can offer a contract that satisfies only the θ-type supplier’s participation constraint. Therefore, she pays

Induced-Effort (IE) contract

In this section, we characterize the optimal menu of contracts for the IE setting that induces a specific process improvement effort on each supplier type. Note that because both the supplier’s type and action are unobservable by the buyer, IE gives the optimal contract under the mixed model of adverse selection followed by moral hazard. Using backward induction, one first needs to characterize the supplier’s process improvement decision. The θ-type supplier decides on the process improvement

Audited-Effort (AE) contract

In the previous section, we show that the buyer’s inability to observe the action taken by the supplier has significant impacts on both information rent and channel inefficiency. In this section, we consider an audit setting in which the buyer receives a perfect signal on the action chosen by the supplier by incurring audit cost A>0 and uses this signal to enforce a particular action profile. Note that it is a common practice for the buyer to obtain independent verification of the supplier’s

The value of audit

We analyze the value of an audit (VOA) from the perspectives of the buyer, the supplier, and the entire channel. First, note that the comparison of channel loss expressions characterized in Propositions 2 and 3 for optimal IE and AE contracts, respectively, imply that the audit is always valuable from the channel perspective. However, to determine the value of an audit for both buyer and supplier, we need to take into account both information rent and channel loss under optimal IE and AE

Conclusions

In this paper, we explore the value of audit for a supply chain where a buyer has to contract with a supplier whose true state of delivery reliability and actions are not observable. We analyzed two contractual mechanisms for the buyer to interact with such suppliers. In the first mechanism, the buyer offers to the supplier a menu of contracts both to screen his reliability and to induce him to exert a process improvement effort (henceforth called Induced-Effort (IE) contract). In the second

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