Sourcing Mechanism and Supply Base Design for
Supplier Competition and Investment of E¤ort
Cuihong Li
Cuihong.Li@business.uconn.edu
School of Business, University of Connecticut, 2100 Hillside Road, Storrs, CT 06269
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Introduction
Manufacturers increasingly rely on suppliers investing e¤ort to create value, reduce costs,
and improve products or services. In order to motivate suppliers to invest e¤ort, many
manufacturers have shrunk their supply base by reducing the number of suppliers. A small
supply base allows an OEM to build deep trust and foster close supplier relationships, thereby
encouraging suppliers to dedicate more resources to improve their performance. Besides a
small supply base, certain commitments made by the OEM to a supplier may also help to
motivate upfront e¤ort investment of the supplier.
While OEMs have realized the advantages of supply base reduction, fewer suppliers are
not necessarily better. A small supply base compromises the bene…t of a competitive marketplace. When fewer suppliers compete for a contract, a buyer (OEM) has less bargaining
power in negotiations with the suppliers, which may cause a higher purchasing cost for the
buyer. In the automotive industry, suppliers provide not merely small parts but completely
assembled and tested systems. Such integrated systems are much harder for OEMs to estimate the cost than simple parts. In such situations, supplier competition helps the buyer
to form reasonable expectations of supplier cost, thereby discovering a fair price. Supplier
competition also mitigates the risk of supplier performance. A supplier may experience performance slips or cost surges due to managerial problems or spikes of material, logistics, or
lower-tier supplier costs. The uncertainty of supplier preformance may also be caused by
the uncertain outcome of innovation and process improvement. With multiple competing
suppliers, a buyer is able to respond to such supplier performance changes by adjusting her
business allocation among suppliers.
In this paper, we study a buyer’s sourcing strategy considering suppliers’investment of
cost-reduction e¤ort and the e¤ect of supplier competition. We focus on two dimensions
of the sourcing strategy: the supply base and the sourcing mechanism. When designing
the supply base, should the buyer involve one or more suppliers in the supply base? In
addition, for the suppliers in the supply base, a buyer may invests in relationship-speci…c
resources to improve their capabilities, as a part of supplier development. A common type
of the investment is speci…c assets, such as facilities, machinery, tools, or equipment that are
customized or dedicated to the buyer’s need. A buyer investing resources for a supplier is
not necessarily exclusive with supplier competition. In fact, even the Japanese auto makers,
who are considered to make substantial relationship-speci…c investment for their suppliers,
often impose their suppliers in competition. Therefore, the buyer may collaborate with a
few suppliers that are in competition for the buyer’s business. Such a situation can be
regarded as an intermediate case between the typical arms-length relationship and long1
term relationship; following the literature, it may be called performance-based partnership,
parallel sourcing, or durable arms-length relationship.
In sourcing mechanism design, the buyer is concerned with the time of contract decisions.
Speci…cally, should the buyer commit on the resource to invest for a supplier and/or the price
at which to source from a supplier before the suppliers invest their e¤ort, or make these
decisions contingent on the realization of supplier performance following their e¤ort? The
ex post decisions are responsive, but may hold-up a supplier’s investment of e¤ort since a
supplier is usually in a weak bargaining position relative to the buyer: With ex post contract
decisions, the supplier’s e¤ort cost is already sunk when the contract is determined. Then
the buyer would demand a price not to cover the supplier’s e¤ort cost. Expecting this, the
supplier would be reluctant to invest e¤ort upfront. To avoid the hold-up problem, the buyer
may choose to make ex ante commitments on the contract terms, giving up the bene…t of
responsive decisions.
Our goal is to develop an understanding of the buyer’s strategy on supply base and
sourcing mechanism design, considering supplier competition and investment of e¤ort. In
the model, there are two available suppliers. The buyer enhances suppliers’delivery capability by investing in their capacity, facing uncertain demand. The suppliers improve their
production e¢ ciency by exerting cost-reduction e¤ort. The realized cost is uncertain and
private information of a supplier.
We analyze and compare three sourcing mechanisms that di¤er on the time of capacity investment and price decisions: 1) the base mechanism, in which the buyer invests in
(commits to) supplier capacity before suppliers make their investment of e¤ort, with the
purchasing prices negotiated (via an optimal auction) afterwards, 2) the ex ante price commitment mechanism, in which the buyer commits to the prices along with the capacities
before suppliers invest their e¤ort, and 3) the ex post capacity investment mechanism, in
which the buyer leaves the capacities to be determined along with the prices after supplier
cost realization. Under each mechanism, the buyer may choose to include one (sole sourcing)
or both suppliers (dual sourcing) in the supply base, and in the case of dual sourcing, the
buyer may invest in equal (symmetric dual sourcing) or unequal (asymmetric dual sourcing)
capacities for the suppliers.
Our analysis addresses the following research questions: First, what is the outcome of
supplier e¤ort and supplier competition given the supply base under each sourcing mechanism? Second, what is the optimal supply base design under each sourcing mechanism?
Finally, what is the optimal sourcing strategy in terms of both the sourcing mechanism
and supply base design? The existing literature ignores either the buyer’s investment of
resources for suppliers or suppliers’improvement e¤ort, and/or assumes an exogenous supply base. We contribute to the literature by studying supply base design as an endogenous
decision, considering both supplier competition and supplier investment of e¤ort.
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Major results
We …nd that the buyer bene…ts from both asymmetry and symmetry between suppliers in
their capacities, when the capacity is invested ex ante before supplier e¤ort. An asymmetric
supply base generates bene…t from suppliers’cost-reduction e¤ort, while a symmetric supply
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base is e¤ective at inducing supplier competition. As a result, the buyer may maximize
supplier asymmetry by adopting sole sourcing, maximize supplier symmetry by adopting
symmetric dual sourcing, or reach a balance by choosing asymmetric dual sourcing, even
though suppliers are ex ante identical. Among these three structures, asymmetric dual
sourcing is possible only if demand is uncertain; without demand uncertainty, the buyer
should choose between sole sourcing and symmetric dual sourcing. Therefore, under the
consideration of both supplier competition and e¤ort, even though suppliers are ex ante
identical, the optimal capacity investment solution involving both suppliers may not be
symmetric when demand is uncertain.
We …nd that increasing demand uncertainty may shift the supply base away from dual
sourcing towards sole sourcing, meanwhile reducing total capacity, when the cost of supplier
e¤ort is low. This result is somewhat counter-intuitive as one may think that a larger
supply base would be more preferrable under more volatile demand. The reason for this
result is that increasing demand uncertainty dampens supplier competition, thus reducing
the value of redundant capacity in inducing supplier competition. Therefore, when investing
in the supply base capacity, the buyer should not only be concerned with the capability
needed to meet uncertain demand (operational capacity), but also consider the capacity
redundancy needed to stimulate supplier competition (strategic capacity). While greater
demand uncertainty typically calls for a greater bu¤er of the operational capacity, it lowers
the value of the strategic capacity. As a result, the total capacity, along with the number of
suppliers, may decrease with demand uncertainty.
Finally, the supply base and sourcing mechanism should be considered jointly, with the
optimal sourcing strategy closely depending on the supplier cost uncertainty: When supplier cost uncertainty is low, the buyer prefers sole sourcing along with making price and
capacity commitments to the single supplier before supplier-cost realization. This is similar
to a long-term relationship. When supplier cost uncertainty is high, the buyer prefers to
include both suppliers in the supply base, and, following the result of supplier competition,
determine the price and capacity investment with the single winning supplier. This is similar
to an arm’s-length relationship. When supplier cost uncertainty is intermediate, then the
buyer may invest capacity for both suppliers upfront, and then determine the prices and
quantity allocation between suppliers after the realization of supplier costs. This is similar
to a performance-based partnership. Our result is consistent with empirical observations.
Japanese auto-makers typically work closely with their suppliers by sharing knowledge and
providing engineering support. This allows the buyer to gain information about a supplier’s
cost structure and keep the cost variation under control. Thus it is reasonable to consider
that the supplier cost uncertainty faced by Japanese OEMs is relatively low. Consistent with
our …nding, Japanese auto-makers often source from a single supplier (or a small number
of suppliers) and set target prices (similar to our ex ante price commitment) for suppliers.
Compared to their Japanese peers, U.S. auto-makers do not work as closely with their suppliers, thus facing relatively high supplier cost uncertainty. Meanwhile, they are more inclined
to engage suppliers in competition by forming a larger supply base, and often renegotiate
prices based on suppliers’achieved costs (similar to our ex post price negotiation).
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