Supply Contracting under Information Asymmetry and Delivery Performance Consideration

A global economy and rapidly-changing market conditions have greatly intensified industry competition. This, in turn, has led to an ever-increasing level of outsourcing/offshoring activities by firms in order to gain cost advantage and market share (Friedman 2005, Hausman et al. 2005). According to the Department of Commerce (2006), typical U.S. manufacturers spend more than half of their revenue on goods and services obtained from external suppliers. As a result, supply management has become a significant issue for many companies that rely more on their suppliers for the delivery of components, products, and services. When sourcing from outside suppliers, a buyer should consider both price and non-price factors. One of the major non-price factors is the supplier’s delivery performance. The benefit of fast, reliable deliveries from a supplier is quite clear from an operations management perspective: It enables the buyer to lower inventory and provide superior service. In other words, the more responsive the supplier is, the lower the buyer’s operating cost (e.g., inventory holding cost plus penalty cost for backorders). The importance of supplier delivery performance in procurement has been emphasized by both practitioners and academics (Burt 1989, Pyke and Johnson 2003). It has been reported that many firms rank price, quality, and delivery performance as the top three criteria for selecting and evaluating suppliers (Kay 2005, CAPS Research 2006). For example, Sun Microsystems considers procurement cost and delivery performance the two most important dimensions when choosing suppliers (Farlow et al. 1996). With the help of recent advances in information technologies, there has been a drastic increase in the use of online auction as a procurement tool (Rangan 1998, Wise and Morrison 2000, Pinker et al. 2003). A challenge in procurement auction design for B2B exchanges is how to bring non-price factors into consideration, including supplier delivery performance (Elmaghraby 2004). These observations call for theoretical research that can generate useful managerial guidelines for procurement process design while taking delivery performance into account. This chapter studies a buyer’s supply contract design problem under delivery performance consideration. A supplier’s delivery performance depends on the supplier’s capacity (if the supplier makes to order) or inventory (if the supplier makes to stock), both of which are costly to invest. For most practical situations, the supplier is a self-interested, independent organization. Thus the buyer needs to offer appropriate incentives to induce sufficient capacity or inventory investment from the supplier. In addition, the supplier may have