The Procurement Recipe When Suppliers Are Risky
Chaturvedi, Aadhaar; Martínez de Albéniz Margalef, Víctor
Original document: Optimal Procurement Design in the Presence of Supply Risk
In 2005, Nestlé Italy withdrew 30 million liters of baby milk from the shelves, after it had been discovered the milk was contaminated.
This embarrassing and costly mistake is just one example of the growing problems of supply-chain reliability in an increasingly globalized marketplace.
While the offshoring of supply and even production may offer companies substantially lower costs, it comes at a hefty price: a much greater risk of supply failure or defective products.
IESE’s Aadhaar Chaturvedi and Victor Martínez-de-Albéniz analyze the best procurement strategies for dealing with risky suppliers.
The procurement divisions of manufacturers must take some of the responsibility for supplier non-conformance of specifications, insufficient quality or external problems such as natural catastrophes or political instability. Indeed, when deciding to work with a supplier, managers must take their perceptions about reliability into account.
In particular, manufacturers need to integrate these elements when using auctions to screen and select suppliers. In other words, they need to value reliability in addition to price.
Optimal Procurement Strategy
The authors propose a model to support managers in building the best procurement strategy in a range of circumstances. It relies on the optimization over all possible auction formats of the buyer profits. The best possible auction is then found that minimizes procurement costs, costs arising from supply failures and informational rents captured by the suppliers.
Reliability Known, Cost Known. With full information available on both cost and reliability, the structure of the buyer’s revenue function needs to be considered. When the buyer knows how much supply quantity is needed, it is best to single source; when the contribution margin depends on the supply quantity, multi-sourcing is the best option.
Reliability Known, Cost Unknown. The allocation in the optimal mechanism is very similar to the full information allocation, except that the cost of each supplier should be inflated (because of the informational rent due to cost uncertainty), with the increment being larger with larger uncertainty on the supplier’s cost.
Reliability Unknown, Cost Known. This situation is an extreme scenario, in which the allocation is identical to the full information allocation, and suppliers obtain zero informational rents. The buyer does not need to give out rents for determining the reliability of suppliers.
Reliability Unknown, Cost Unknown. In this situation, the optimal mechanism has a similar structure to the other cases, provided that a technical condition is satisfied, which can be verified in most reasonable situations. This indicates that the informational rents due to uncertainty in reliability are minor compared with those arising from cost information asymmetries.