Do suppliers care enough?

14 June 2018

Exploding smartphones due to overheating batteries, grounded airplanes due to engine turbine faults, large-scale car recalls due to airbag defects: All these are recent examples of product failures caused by the components developed and procured by external suppliers.

As businesses increasingly rely on supplier expertise when developing new products and services, these issues inevitably become more common. Small businesses are not spared. For example, they may need to involve external parties to design their logo or packaging, and the quality of the outcome might vary drastically.

Are these failures purely random? I.e., could they happen even if all the components and services were developed in-house? Or are we facing a systemic incentive misalignment when external suppliers do not make enough effort developing, testing and improving their components? In other words, do suppliers care enough about components developed for third parties?

Theory of incentives tells us that a supplier’s effort largely depends on the type of contract signed with them. Ideally, one could specify the supplier’s remuneration, contingent on the efforts they make. In such a case, the supplier’s incentives perfectly align with the clients. More effort leads to higher supplier payouts and a higher quality output. However, this approach faces two substantial practical difficulties: One, the supplier’s efforts must be observable or at least verifiable and, two, the client must know how much effort, what tests and what improvements are necessary. Observing what the supplier does might prove to be excessively costly, if possible at all, and knowledge about what needs to be done is also often hard to obtain.

An alternative contract theoretically capable of creating the right incentives is the performance-based contract, the contract specifying different payments to the supplier based on the quality of the output. Under this contract, higher quality usually correlates to higher payment, while low quality may incur penalties. In order to design the optimal contract, one needs to keep two important considerations in mind. First, the supplier needs to find it profitable to work harder to achieve a higher payment level meaning the payment to the supplier has to increase steeply in relation to quality. Second, the supplier needs to accept the contract in the first place. For example, a risk-averse supplier may turn down the contract if the range of possible payments is too wide because the final outcome depends not only on the supplier’s efforts but also on a number of random factors beyond their control.

While performance-based contracts can work well in some instances, they also have important limitations to consider. For example, the supplier might have a limited liability meaning that penalties for low quality might be hard to implement. Furthermore, the suppliers are often risk averse and might turn down contracts with a wide range of possible payments or penalties, especially in an uncertain environment. Under these conditions, it is often impossible to force the supplier to  exert the desired level of effort. However, with careful selection and calibration of contract parameters one can drastically reduce the optimality gap.

 

Timofey Shalpegin
Lecturer