The Comparison of Two Vertical Outsourcing Structures under Push and Pull Contracts

In a three‐tier supply chain comprising an original equipment manufacturer (OEM), a contract manufacturer (CM), and a supplier, there exist two typical outsourcing structures: control and delegation. Under the control structure, the OEM contracts with the CM and the supplier respectively. Under the delegation structure, the OEM contracts with the CM only and the CM subcontracts with the supplier. We compare the two outsourcing structures under a push contract (whereby orders are placed before demand is realized) and a pull contract (whereby orders are placed after demand is realized). For all combinations of outsourcing structures and contracts, we derive the corresponding equilibrium wholesale prices, order quantities, and capacities. We find that the equilibrium production quantity is higher under control than under delegation for the push contract whereas the reverse holds for the pull contract. Both the OEM and the CM prefer control over delegation under the push contract. However, under the pull contract, the OEM prefers control over delegation whereas the CM and the supplier prefer delegation over control. We also show that for a given outsourcing structure, the OEM prefers the pull contract over the push contract. In extending our settings to a general two‐wholesale‐price (TWP) contract, we find that when wholesale prices are endogenized decision variables, the TWP contract under our setting degenerates to either a push or a pull contract.     

On the Advantage of Quantity Leadership When Outsourcing Production to a Competitive Contract Manufacturer

This study investigates a supply chain comprising an original equipment manufacturer (OEM) and a contract manufacturer (CM), in which the CM acts as both upstream partner and downstream competitor to the OEM. The two parties can engage in one of three Cournot competition games: a simultaneous game, a sequential game with the OEM as the Stackelberg leader, and a sequential game with the CM as the Stackelberg leader. On the basis of these three basic games, this study investigates the two parties' Stackelberg leadership/followership decisions. When the outsourcing quantity and wholesale price are exogenously given, either party may prefer Stackelberg leadership or followership. For example, when the wholesale price or the proportion of production outsourced to the CM is lower than a threshold value, both parties prefer Stackelberg leadership and, consequently, play a simultaneous game in the consumer market. When the outsourcing quantity and wholesale price are decision variables, the competitive CM sets a wholesale price sufficiently low to allow both parties to coexist in the market, and the OEM outsources its entire production to this CM. This study also examines the impact of the supply chain parties' bargaining power on contract outcomes by considering a wholesale price that is determined via the generalized Nash bargaining scheme, finding a Stackelberg equilibrium to be sustained when the CM's degree of bargaining power is great and the non‐competitive CM's wholesale price is high.     

Contracting for Capacity under Renegotiation: Partner Preferences and the Value of Anticipating Renegotiation

This paper studies contract renegotiation in a stylized supply chain model. Two original equipment manufacturers (OEMs) sign fixed‐quantity contracts with a contract manufacturer (CM) prior to demand realization. Contract renegotiation after demand realization allows the OEMs to use capacity that is more or less than what they contracted for. We assume that the extra profit due to efficient allocation of capacity is allocated to the supply chain parties according to the egalitarian rule and investigate when an OEM's expected post‐renegotiation profit is maximized. We aim to understand how an OEM's expected post‐renegotiation profit is affected by her ability to negotiate a low wholesale price in the initial contract as well as the ability of the other OEM to do the same. Regardless of whether renegotiation is anticipated or not at the time of the initial contract, we find that an OEM, who had weak buyer power vis‐a‐vis the CM and was unable to negotiate a low wholesale price in the initial contract, may benefit more from renegotiation than a stronger OEM. In addition, we show that how the expected post‐renegotiation profit of an OEM changes with demand variance or anticipating renegotiation depends on the strength of the OEM's buyer power. Finally, we numerically test the robustness of our results in a supply chain with three OEMs and also identify when the OEMs prefer to leave the CM out of the renegotiation.     

Forecast Updating and Supplier Coordination for Complementary Component Purchases

We study a supply chain where an original equipment manufacturer (OEM) buys subassemblies, comprised of two complementary sets of components, from a contract manufacturer (CM). The OEM provides a demand forecast at the time when the CM must order the long lead‐time set of components, but must decide whether or not to provide updated forecasts as a matter of practice. Forecast updates affect the CM's short lead‐time purchase decision, and the anticipation of updates may also affect the long lead‐time purchase decision. While the OEM and CM both incur lost sales costs, the OEM can decide whether or not to share the overage costs otherwise fully borne by the CM. We investigate when the OEM is better served by committing to provide updated forecasts and/or committing to share overage costs. For a distribution‐free, two‐stage forecast‐update model, we show that (1) the practice of providing forecast updates may be harmful to the OEM and (2) at the OEM's optimal levels of overage risk sharing, the CM undersupplies relative to the supply chain optimal quantity. For a specific forecast‐update model, we computationally investigate conditions under which forecast updating and risk sharing are in the best interest of the OEM.     

The Role of Revenue‐Focused Managerial Performance Measures in Supply Chain Coordination

Many firms employ revenue‐focused managerial performance measures (RF‐MPMs) that cause managers to worry more about revenues than about costs. Although this can seemingly misalign the interests of a manager, we show that the use of such measures can help supply chain partners to overcome hold‐up issues with respect to capacity and promotion investments. We develop a game theoretic model in which two supply chain partners engage in repeated interactions in which the supplier invests in capacity and the buyer invests in demand promotion. Following the realization of demand in each period, the two firms negotiate over the output quantity and wholesale price. The novelty of our model is that we allow the owners of each firm to delegate decision‐making power and negotiating responsibility to a free‐agent manager. We characterize the conditions under which the owners of both firms employ RF‐MPMs in equilibrium and benefit from doing so. For a special case of our model, we show that for the owners of the buyer, an RF‐MPM is equivalent to a price only relational contract, and that it complements a price and quantity relational contract as a mechanism for mitigating hold‐up issues.     

The Impact of Switching Costs on the Outsourcing of Knowledge‐Intensive Business Processes

This study examines the impact of switching costs on vendor selection and contract efficiency in the outsourcing of knowledge‐intensive business services (KIBS). We show that under most plausible scenarios in KIBS outsourcing, there is an intrinsic tension between vendor selection and contract efficiency: in the process in which the winning vendor's bid constitutes the terms of the contract between client and vendor (e.g., competitive bidding), there is good selection but contract inefficiency (positive information rent paid by the client). If, by contrast, the client establishes the contract terms, then its performance yields contract efficiency but poor selection. We also highlight the implications of performance metrics for contract design in KIBS outsourcing.     

Analysis of the Market‐Based Adjustable Outsourcing Contract under Uncertainties

The market‐based adjustable contract for customized goods or services has emerged in outsourcing practices. Its objective is to minimize the operational risks inherent in today's volatile environment of operations. Our research reveals several important properties of this contract through a continuous‐time analytical approach. Specifically, we consider the determination of this contract between two risk‐averse firms through a Nash bargaining process. We derive the optimal adjusting mechanism analytically and extensively analyze the application boundary of the market‐based adjustable outsourcing contract. We conclude by discussing implications for practice and research.     

Managing Quality in a Heterogeneous Contract Manufacturing Environment

The outsourcing of production is a prominent strategy across industries. While the strategy can have many benefits, the popular press reports numerous examples of quality issues originating with contract manufacturers (CMs). Observing these quality issues, multiple scholars call for the quality management (QM) literature to be extended to explicitly address the challenges of managing quality in an inter‐organizational context. Additionally, QM researchers recognize the need to consider contextual contingencies for the effectiveness of specific QM practices. Responding to these calls, we focus on the potential contingent factor of CM heterogeneity (i.e. the degree of product and process diversity at the CM plant). We first test the direct relationship between CM manufacturing heterogeneity and CM quality conformance performance, as reported by the CM's customers, brand‐owning firms. Next, we evaluate the effectiveness of multiple practices that these brand‐owning firms can employ to mitigate the anticipated negative effect of heterogeneity on their CM's conformance quality. We utilize paired dyadic data on 106 contract manufacturing relationships in the food, drug, and medical device industries to test our hypothesized model. The results of our analysis reveal a negative association between heterogeneity at CM facilities and their conformance quality performance. Our results also identify cooperative relationships, contractual coordination provisions, and formal performance assessment programs as practices that brand‐owning firms can employ to largely eliminate the negative impact of heterogeneity on CMs’ conformance quality performance.     

The Effect of Learning and Integration Investment on Manufacturing Outsourcing Decisions: A Game Theoretic Approach

We introduce a two‐period Stackelberg game of a supplier and buyer. We recognize that learning from manufacturing experience has many advantages. Consistent with the literature, we assume both the buyer and supplier realize reductions in their respective production costs in period 2 due to volume‐based learning from period 1 production. In addition, we introduce another learning concept, the future value, to capture the buyer's benefits of transferring current manufacturing experience for the design and development of future products and technologies. In contrast to the literature, we allow the supplier two mechanisms to impact the buyer's outsourcing decision: price and the investment in integration process improvement (IPI) that reduces the buyer's unit cost of integration. IPI may include the investment in new materials, specialized technology, or the re‐design of the integration process. Conditions are given whereby the buyer partially outsources component demand as opposed to fully outsourcing or fully producing in‐house. Furthermore, conditions are given characterizing when the supplier's price and investment in IPI are substitute strategies versus complements. Both analytic and numerical results are presented.     

Delegation vs. Control in Supply Chain Procurement under Competition

This paper studies the optimal component procurement strategies of two competing OEMs selling substitutable products. The OEMs outsource their production to a common contract manufacturer, who in turn needs an input from a component supplier. Each OEM may either directly procure the input from the component supplier, or delegate the procurement task to the contract manufacturer. We first analyze the OEMs' procurement game under a non‐strategic supplier whose component price is exogenously given. It is found that symmetric equilibria arise for most situations, that is, both OEMs either control or delegate their component procurement in equilibrium. Interestingly, despite the commonly‐held belief that the contract manufacturer would be worse off as OEMs gain component procurement control, we show that the contract manufacturer may enjoy a higher profit. Then we study the OEMs' procurement game under a strategic supplier who can set its component price. We find that the supplier's strategic pricing behavior plays a critical role in the equilibrium procurement structure. In particular, in the equilibrium under strategic supplier, the larger OEM always uses delegation while the smaller OEM may use either delegation or control. By identifying the driving forces behind the OEMs' procurement choices, this research helps explain observed industry practices and offer useful guidelines for firms' component sourcing decisions.     

Competing on Time: An Integrated Framework to Optimize Dynamic Time‐to‐Market and Production Decisions

This study develops a comprehensive framework to optimize new product introduction timing and subsequent production decisions faced by a component supplier. Prior to market entry, the supplier performs process design activities, which improve manufacturing yield and the chances of getting qualified for the customer's product. However, a long delay in market entry allows competitors to enter the market and pass the customer's qualification process before the supplier, reducing the supplier's share of the customer's business. After entering the market and if qualified, the supplier also needs to decide how much to produce for a finite planning horizon by considering several factors such as manufacturing yield and stochastic demand, both of which depend on the earlier time‐to‐market decision. To capture this dependency, we develop a sequential, nested, two‐stage decision framework to optimize the time‐to‐market and production decisions in relation to each other. We show that the supplier's optimal market entry and qualification timing decision need to be revised in real time based on the number of qualified competitors at the time of market‐entry decision. We establish the optimality of a threshold policy. Following this policy, at the beginning of each decision epoch, the supplier should optimally stop preparing for qualification and decide whether to enter the market if her order among qualified competitors exceeds a predetermined threshold. We also prove that the supplier's optimal production policy is a state‐dependent, base‐stock policy, which depends on the time‐to‐market and qualification decisions. The proposed framework also enables a firm to quantify how market conditions (such as price and competitor entry behavior) and operating conditions (such as the rate of learning and inventory/production‐related costs) affect time‐to‐market strategy and post‐entry production decisions.     

The Impact of Outsourced Manufacturing on Timing of Entry in Uncertain Markets

Several firms are interested in manufacturing and selling new products based on a new process technology. Before manufacturing can begin, either these Original Equipment Manufacturers (OEMs), or a Contract Manufacturer (CM) needs to adopt the process technology, i. e., make a capacity investment in it. Due to market uncertainty, the timing of capacity investment is crucial. In such a setting, we investigate how the timing of process adoption, an important determinant of time‐to‐market, is impacted by the make/buy decision. We first characterize the optimal time for process adoption and show that this delay depends on competitive intensity, cost structure and the rate of forecast improvement. Due to differing cost structures, incentives and risks, an OEM and a CM may invest in a new process technology at different times. We show that while there are conditions where outsourced manufacturing can be advantageous for the OEM from a time‐to‐market perspective, there are also cases where the OEM would be disadvantaged. In these cases, the OEM can accelerate process adoption by risk sharing through joint investment. Finally, the right choice of CM is extremely important for an OEM that faces a short time window for product introduction: An efficient CM not only provides low costs but also rapid access to new process technologies, and therefore higher revenues.     

Should an OEM Retain Component Procurement when the CM Produces Competing Products?

We consider a large original equipment manufacturer (OEM) who relies on a contract manufacturer (CM) to produce her product. In addition to the OEM's product, the CM also produces for a smaller OEM. Both the larger OEM and the CM can purchase the component from the supplier, but their purchase prices may differ and remain unknown to each other. The main question we address is whether the larger OEM should retain component procurement by purchasing components from the supplier and reselling to the CM (buy–sell), or outsource component procurement by letting the CM purchase directly from the supplier (turnkey). We show that, under buy–sell, the larger OEM's optimal strategy is to resell components at the highest possible component purchase price of the CM (i.e., the street price). By comparing buy–sell and turnkey, we find that a CM with low component price is better off under turnkey, even though under buy–sell he receives more profits through the products sold to the smaller OEM. Furthermore, the larger OEM's preference between buy–sell and turnkey depends on her component price, the volatility of the CM's component price and substitutability between the two products.     

The Impact of Costliness,Competitive Importance,and Modularity of Investments on Outsourcing

This study is motivated by examples of outsourcing that are not readily explained by widely established economic theories. We extend recent literature that develops the idea that outsourcing can help firms avoid overinvestment by specifying more precisely the conditions under which this thesis is likely to apply. Our extension is realized through a two‐period game theoretic model in which the outsourcing and in‐house investments are driven by (1) the cost required to develop a product or process module, (2) competitive relevance, defined as the module's share in the production cost or the module's importance to the customer, and (3) modularity, defined as the extent to which generic investments in the module can approach firm‐specific investments in terms of the overall product/process performance. The analysis generates predictions about what types of insourcing, outsourcing, and non‐sourcing behaviors are likely to emerge in different parts of the parameter space. Outsourcing to a more concentrated industry upstream emerges at equilibrium when modularity is high, relevance low to medium, and development cost high enough that none or only a subset of focal firms wants to invest. While firms are forced to insource and overinvest due to a prisoner's dilemma when the development cost is sufficiently high relative to the module's relevance, we do not find outsourcing equilibria that solve this problem in a two‐period game with no commitment. This result implies that some form of tacit coordination in a multi‐period game may be necessary. We conclude the study with a discussion of empirical implications.     

Production,Process Investment,and the Survival of Debt‐Financed Startup Firms

Whether to invest in process development that can reduce the unit cost and thereby raise future profits or to conserve cash and reduce the likelihood of bankruptcy is a key trade‐off faced by many startup firms that have taken on debt. We explore this trade‐off by examining the production quantity and cost reducing R&D investment decisions in a two period model wherein a startup firm must make a minimum level of profit at the end of the first period to survive and operate in the second period. We specify a probabilistic survival measure as a function of production and investment decisions to track and manage the risk exposure of the startup depending on three key market factors: technology, demand, and competitor's cost. We develop managerial insights by characterizing how to create operational hedges against the bankruptcy risk: if a startup makes a “conservative” investment decision, then it also selects an optimal quantity that is less than the monopoly level and hence sacrifices some of first period expected profits to increase its survival chances. If it decides to invest “aggressively,” then it produces more than the monopoly level to cover the higher bankruptcy risk. We also illustrate that debt constraint shrinks the decision space, wherein such process investments are viable.     

Managing High‐Tech Capacity Expansion via Reservation Contracts

We study capacity reservation contracts between a high‐tech manufacturer (supplier) and her OEM customer (buyer). The supplier and the buyer are partners who enter a ‘design‐win” agreement to develop the product, and who share the stochastic demand information. To encourage the supplier for more aggressive capacity expansion, the buyer reserves capacity upfront by paying a deductible fee. As capacity expansion demonstrates diseconomy of scale in this context, we assume convex capacity costs. We show that as the buyer's revenue margin decreases, the supplier faces a sequence of four profit scenarios with decreasing desirability. We examine the effects of market size and demand variability to the contract conditions. We propose two channel coordination contracts, and discuss how such contracts can be tailored for situations where the supplier has the option of not complying with the contract, and when the buyer's demand information is only partially updated during the supplier's capacity lead‐time.     

The Impact of Contract Manufacturing on Inventory Performance: An Examination of U.S. Manufacturing Industries

In recent years, a growing number of original equipment manufacturers (OEMs) have transferred their manufacturing processes to specialized firms, known as contract manufacturers. In so doing, contract manufacturers can reduce an OEM's production costs and provide OEMs with flexibility in the production process. We examine another potential reason for the use of contract manufacturing—the potential for efficiency gains from inventory reductions. Employing econometric models and data representing manufacturing industries in the USA, we provide statistical evidence that contract manufacturing can lead to lower industry‐wide inventory levels, after controlling for other relevant factors. Key managerial implications are derived from the analysis.     

OEM product design in a price competition with remanufactured product

An original equipment manufacturer (OEM) produces new products and often faces a dilemma when determining the level of interchangeability in its product design. The interchangeability is considered as a degree to which the product can be disassembled without force, and thus an increasing degree of interchangeability would decrease the OEM's production cost, but it would also lower a remanufacturer's cost in cannibalizing used items. Decreasing the level of interchangeability to deter the remanufacturer, on the other hand, would simultaneously increase the production costs of the OEM. We thus formulate a two-period supply chain model consisting of two chain members, an OEM and a remanufacturer, to investigate the product design decision of the OEM and both chain members' competitive pricing strategies. We then characterize the equilibrium decisions and profits with regard to costs and consumers' preference for the remanufactured product. We also evaluate a strategic game in which the OEM chooses the degree of interchangeability, and the remanufacturer determines its collection strategy. We find that the product-design strategy is effective for the OEM in competing with the remanufacturer, but it is not necessarily harmful to the remanufacturer.     

Complexity as a Contract Design Factor: A Human‐to‐Human Experimental Study

Despite being theoretically suboptimal, simpler contracts (such as price‐only contracts and quantity discount contracts with limited number of price blocks) are commonly preferred in practice. Thus, exploring the tension between theory and practice regarding complexity and performance in contract design is especially relevant. Using human subject experiments, Kalkancı et al. (2011) showed that such simpler contracts perform effectively for a supplier interacting with a computerized buyer under asymmetric demand information. We use a similar set of experiments with the modification that a human supplier interacts with a human buyer. We show that human interactions strengthen the supplier's preference for simpler contracts. We find that suppliers have fairness concerns even when they interact with computerized buyers. These fairness concerns tend to be even stronger when suppliers interact with human buyers, particularly when the complexity of the contract is low. We also find that suppliers are more prone to random decision errors (i.e., bounded rationality) when interacting with human buyers. In the absence of social preferences, Kalkancı et al. identified reinforcement and bounded rationality as key biases that impact suppliers' decisions. In human‐to‐human experiments, we find evidence for social preference effects. However, these effects may be secondary to bounded rationality.     

Outsourcing Manufacturing: Secure Price‐Masking Mechanisms for Purchasing Component Parts

This paper develops and tests a privacy‐preserving business process that supports the selection of a contract manufacturer by an original equipment manufacturer (OEM), and the determination of whether the OEM or the chosen contract manufacturer will procure each of the components to be used in the manufacture of the OEM's branded product. Our “secure price‐masking (SPM)” technology contributes to procurement theory and practice in four significant ways: First, it preserves the privacy of every party's individual component prices. Second, SPM assures that the contract manufacturers will bid their own private purchase cost (i.e., not add a margin to their cost). Third, SPM is not invertible; i.e., none of the participants can “solve” for the private inputs of any other participant based on its own inputs and the outputs provided to it by SPM. Fourth, the posterior distribution of any other participant's private inputs is practically indistinguishable from its prior distribution. We also describe the results of a proof‐of‐concept implementation.