Mitigate Supplier Responsibility Risk in Emerging Economies: An Ethical Sourcing Framework

Sourcing from emerging economies may yield direct cost savings, but companies often face greater risk of supplier responsibility problems due to many factors, with lax regulatory enforcement in these regions being one of them. Intuitively, to mitigate such risks, companies can design incentive schemes in sourcing contracts and invest in screening mechanisms for supplier sourcing. However, the relative effectiveness of these actions is often not known. To address this problem, we first develop a model that captures the supplier’s rational decision making. Under this model, the supplier responsibility risk is endogenized and can be influenced by various factors, including the supplier’s intrinsic ethical level. We then propose to use a delayed payment contract to mitigate supplier responsibility risk. When the supplier’s intrinsic ethical level is unobservable to the buyer, we study the optimal screening mechanism based on the delayed payment contract. Surprisingly, we find that, when the buyer anticipates a high cost impact as a result of supplier responsibility problems, the optimal screening mechanism collapses to a random selection. To remedy this problem, we further consider screening mechanisms involving voluntary or mandatory supplier certification. We show that both certification mechanisms can help mitigate supplier responsibility risk in certain cases. Specifically, a properly designed mandatory certification can help the buyer to achieve the first-best performance when the cost impact from supplier responsibility problems is high.