Agenda Contract manufacturing: Pros vs. Cons Informational issues - - PDF document

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Mohammad Nikoofal

Ted Rogers School of Management Ryerson University, Toronto, Canada

Mehmet Gumus

Desautels Faculty of Management McGill University, Montreal, Canada Ferdowsi University of Mashhad Department of Industrial Engineering

Quality at the Source or at the End? Managing Supplier Quality Under Information Asymmetry

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Agenda

Ø Contract manufacturing: Pros vs. Cons Ø Informational issues in contract manufacturing Ø The importance of adverse selection and moral hazard in manufacturing è Research Questions Ø Model development and analysis Ø Managerial Insights

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$245 $278

Contract Manufacturing as a Business Model Innovation

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* Supply Chain Brutalization (The handbook of Contract Manufacturing) by “Walt Grischuk”

Contract Manufacturing: Real World Motivations

Ø In a contract manufacturing business model, a buyer contracts with a supplier for manufacturing of some components of product or whole product. Ø It becomes a dominant business model*:

§ Of $1 trillion manufacturing market, $300 billion is outsourced to contract manufacturers. § Less than 25% of an automobile is manufactured by the automaker. § In the case of many innovative products, more than 85% of the manufacturing is

• utsourced to CMs.

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Benefits Risks

Contract Manufacturing: Pros vs. Cons

1. Lack of control/visibility

• ver suppliers’ risk

management practices 2. Lack of time and resources 3. Lack of tools, frameworks, and decision-making structures for supply-chain risk management

* Physical risks to the supply chain: the view from finance; CFO Publishing Corp, 2009

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Ø What are the greatest obstacles to improving supply-chain risk management at your company*?

Lack of Control/Visibility over Supplier Tops the List

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1. Visibility over the “conditions” under which the contract manufacturer is working (e.g., operational capability, level of experience in production planning, supplier’s flexibility): Ø Philips had better understanding about the consequences of lightning storm than Nokia & Ericsson Ø Japanese car firms weekly shutdowns due to power shortage in 2011 after Tsunami in Japan 2. Visibility over the “actions” that contract manufacturer takes: Ø Dozens of deaths from the blood thinner Heparin Ø Toyota audit finds misunderstanding with suppliers

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Adverse Selection Moral Hazard

Two-dimensional Visibility Risk

Ø Recalling 8 million vehicles around the world due to the malfunctioning gas pedals in 2009-2010 Ø Toyota sent the auditors to its most trusted suppliers Ø A surprising result for Toyota:

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Instead of testing parts four times a year, these highly trusted suppliers were testing them only once every year!

Toyota Audit Finds “Misunderstanding” with Suppliers

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Two Contracts to Deal with Visibility Issues

Ø Dealing with lack of information in the supply chain, firms use contract manufacturers to inspect their suppliers’ end-products and their production- related decisions and link their incentives to the outcomes of these inspections. Ø There are two types of inspections:

1. Those that test whether the quality of the final output conforms to the standards prespecified by the manufacturer Ø We call it Quality at-the-End (QE) contract Ø Payment is contingent on the end product’s quality 2. Those that test the suppliers’ actions that affect the quality of the final product Ø We call it Quality-at-the-Source (QS) contract Ø Payment is released to the supplier based on the actual quality-effort decision made at source

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Manufacturer Reliable supplier (𝒊-type, 𝜾 = 𝒊) Unreliable supplier (𝒎-type, 𝜾 = 𝒎)

𝟐 − 𝝃 𝝃

𝒓 )𝒊𝝑{𝟏, 𝟐} 𝒓 )𝒎𝝑{𝟏, 𝟐}

Supplier

The Supply Chain Model

• 1. Given 𝑓0 = 𝑓1 = 𝑓 ∈ 0,1 è 𝑞0 𝑓 ≥ 𝑞1 𝑓
• 2. For 𝜄-type supplier where 𝜄 ∈ ℎ, 𝑚 :

𝑞: 𝑓: = 1 ≥ 𝑞: 𝑓: = 0

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Timing of Events and Decisions

Manufacturer chooses between “QE” and “QS” Manufacturer offers a menu of contracts: 𝜕:, 𝑍

: under “QE”

contract, and 𝜕:, 𝑍

:, 𝐹: under

“QS” contract Under “QE” contract, the manufacturer decides whether or not to inspect the quality of outcome and pays 𝑍

: only if 𝑟

? = 1 Supplier runs production, and the

• utcome 𝑟

?: is realized Supplier picks a contract and receives upfront payment 𝜕:

Contracting stage Execution stage Improvement stage

Under “QS” contract, the manufacturer decides whether or not to audit the supplier’s effort and pays 𝑍

: only if 𝑓: = 𝐹:

Supplier decides on quality improvement effort 𝑓: ∈ 0,1 Supplier observes the state of his reliability type, 𝜄 ∈ 𝑚, ℎ Time

𝝏𝜾: payable by the manufacturer to the supplier upon the supplier’s participation 𝒁𝜾 QE è payable to the supplier if quality inspection confirms that the quality of the product is acceptable QS è payable to the supplier if audit reports that 𝒇𝜾 = 𝑭𝜾

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Research Questions

Research Question 1: What is the impact of the optimal QE and QS contracts on the incentives of the manufacturer and the supplier as well as the reliability of the entire supply chain? Research Question 2: Which one of the above incentive and inspection mechanisms should be employed by a manufacturer in dealing with a risky supplier? Research Question 3: How does asymmetric information affect the value

• f each contracting strategy from the perspective of each of the individual

supply chain parties as well as the supply chain as a whole?

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Complete Information (First-Best) Scenario

Ø As a benchmark, suppose that both manufacturer and supplier work together as an integrated firm. Ø Let “fb” indicate the first-best level of improvement effort. Ø The integrated firm’s optimization problem is to find the optimal level

• f improvement efforts 𝑓:

EF ∈ 0,1 .

Ø Under the first-best outcome, the integrated firm invests in quality improvement efforts, i.e., 𝑓:

EF = 1, if 𝐷H ≤ 𝑞: 1 − 𝑞: 0 𝑠.

If 𝒇𝜾

𝐠𝐜 = 𝟐 è 𝒒𝜾 𝟐 𝒔 − 𝒅 − 𝑫𝒓

If 𝒇𝜾

𝐠𝐜 = 𝟏 è 𝒒𝜾 𝟏 𝒔 − 𝒅

VS.

Quality at-the-End (QE) Contract

Ø After production is complete, the manufacturer decides whether to perform a quality inspection test 𝑈 = 1 (at the cost of 𝜔S) or not 𝑈 = 0. Ø Contingent payment 𝑍

::

§ 𝑈 = 1: if the production outcomes pass the test (i.e., 𝑟 ?: = 1). § 𝑈 = 0: payable irrespective of the quality of production outcomes.

Ø Degree of “inaccuracy” of the test: 𝜈S = Pr Test report non−defective ∣ 𝑟 ?: = 0 . Quality Inspection Game

𝜷𝜾 𝟐 − 𝜷𝜾 𝜸𝜾 𝟐 − 𝜸𝜾

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Analysis of Quality Inspection Game

Ø After we characterize all the Nash equilibria of the inspection subgame, the next step is to find the

• ptimal QE contract that

would induce each Nash equilibrium. Ø Because there are 4 different equilibria, we need to solve 4 different

• ptimal contract
• ptimization problems.

!"

Cost of quality test for manufacturer #$ Cost of improvement for %-type supplier

#$ # &$

Region III – Pure strategy: Manufacturer inspects, and supplier stops exerting effort '(, *( = 1,0 Region I – Pure strategy: Manufacturer inspects, and supplier exerts effort '(, *( = 1,1 Region II – Mixed strategy: Manufacturer performs inspection with probability '( ∈ 0,1 , and %-type supplier exerts effort with probability *( ∈ 0,1 Region IV – Pure strategy: Manufacturer stops inspection, and supplier stops exerting effort '(, *( = 0,0

!"/

Optimal QE Contract

Individual Rationality (Participation) constraints Incentive Compatibility (IC) constraints Moral hazard constraint Ø At the last stage of our analysis, we compare the optimal QE contracts that are implementable and identify the one that maximizes the manufacturer’s expected profit.

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Agency Costs under QE Contract

Moral Hazard followed by Adverse Selection

Ø There are two types of agency costs under each equilibria:

• 1. Channel loss: When the decisions are different from first-best efforts.

a) Direct cost: the manufacturer performs quality inspection, under which she incurs 𝜔S with probability 𝛽:. b) Indirect cost: where the supplier does not make quality improvement efforts where he does under first-best outcome. Channel loss under QE contract

Agency Costs under QE Contract (Cont.)

Moral Hazard followed by Adverse Selection

Ø There are two types of agency costs:

• 2. Information rent: To satisfy the IC constraint of the ℎ-type supplier, the

manufacturer has to pay a net amount, which the supplier will earn if he deviates and mimics the 𝑚-type.

• a. Moral hazard term: when ℎ and 𝑚 types make different quality improvement

efforts, i.e., 𝛾0 ≠ 𝛾1.

• b. Reliability asymmetry term: because 𝑚- and ℎ-type suppliers are inherently

different in their degrees of reliability. Information rent under QE contract

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Optimal QE Contract Optimal QE Contract (Cont.)

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Quality at-the-Source (QS) Contract

Ø The supplier decides whether to make quality improvement efforts and the manufacturer decides whether to audit the supplier’s efforts 𝐵 = 1 (at the cost of 𝜔d) or not 𝐵 = 0. Ø The 𝜄-type supplier receives the contingent payment 𝑍

:

§ If 𝐵 = 1: payable if 𝑓: = 𝐹:. § If 𝐵 = 0: payable irrespective of supplier’s effort decision. Ø Let § 𝛿:: probability that the manufacturer audits the 𝜄-type supplier’s effort § 𝛾:: probability that the 𝜄-type supplier exerts quality improvement effort

Audit Game

𝜹𝜾 𝟐 − 𝜹𝜾 𝜸𝜾 𝟐 − 𝜸𝜾 𝜹𝜾 𝟐 − 𝜹𝜾 𝜸𝜾 𝟐 − 𝜸𝜾

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Analysis of Quality Audit Game

Ø After we characterize all the Nash equilibria of the audit subgame, the next step is to find the

• ptimal QS contract

that would induce each Nash equilibrium. Ø Because there are 3 different equilibria, we need to solve 3 different

• ptimal contract
• ptimization problems.

!"

Cost of audit for manufacturer #$ Cost of improvement for %-type supplier

Region II: Pure strategy: Manufacturer inspects, and supplier does not exert effort &', )' = 1,0 Region III: Pure strategy: Manufacturer does not audit, and supplier does not exert effort &', )' = 0,0

• − /$ 01
• − /$ 01

Region I: Mixed strategy: Manufacturer performs inspection with probability &' ∈ 0,1 , and supplier exerts improvement with probability )' ∈ 0,1

Optimal QS Contract

Individual Rationality (Participation) constraints Incentive Compatibility (IC) constraints Moral hazard constraint Ø At the last stage of our analysis, we compare the optimal QS contracts that are implementable and identify the one that maximizes the manufacturer’s expected profit.

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Agency Costs under QS Contract

Channel Loss

Ø There is only one type of agency costs under each equilibria:

• 1. Channel loss: When the decisions are different from first-best efforts.

a) Direct cost: the manufacturer performs costly audit, under which she incurs 𝜔d with probability 𝛿:. b) Indirect cost: the supplier does not make quality improvement efforts where he does under first-best outcome. Channel loss under QS contract

Agency Costs under QS Contract (Cont.)

Information Rent

Ø Under the optimal QS contract, the manufacturer makes the contingent payment based on the effort, while under the optimal QE contract, she pays based on the

• utput.

Ø The private information (i.e., the difference in reliability between ℎ- and 𝑚-type suppliers) affects only the output and not the level of effort. Ø Therefore, the contingent payment under the optimal QS contract turns out to be type independent, whereas under the optimal QE contract, it is necessarily type dependent. Ø Under the optimal QS contract, it is sufficient for the manufacturer to offer a pooling contract, which in turn eliminates the need for paying information rent because of the difference in reliability between suppliers.

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Optimal QS Contract QE or QS? 𝒅 ≤ 𝒒𝜾 𝟐 − 𝒒𝜾 𝟏 𝒔

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QE or QS? 𝒅 > 𝒒𝜾 𝟐 − 𝒒𝜾 𝟏 𝒔

Green: the optimal QS dominates the optimal QE Red: the optimal QE dominates the optimal QS White: indifference between the optimal QS and QE contracts

§ QS ensures that required effort is made, but not the required output! § Failure risk borne by the manufacturer under the optimal QS § Manufacturer rectifies this under QE, hence he can conduct inspection under higher value of 𝜔 § When 𝑑 increases, the optimal QS contract becomes more likely equilibrium. § The production cost 𝑑 is paid as a fixed term under QE, but as a contingent term under QS contract. § It increases the power of QS contract.

The Optimal Combined QE and QS Contracts

Ø The manufacturer offers 𝜕:, 𝑍

:, 𝐹: .

Ø The contingent payment 𝑍

: is tied to the outcomes of both the audit and the

inspection.

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The Optimal Combined QE and QS Contracts (Cont.)

Ø The quality improvement effort can be implemented

• nly under the optimal

combined QE and QS contract when both inspection and audit tests are not very accurate; 𝜈S > 𝜈̅S and 𝜈d > 𝜈̅d.

Managerial Insights

Ø Generally speaking;