Reducing Risks in Design Outsourcing of Complex Systems via Prototyping

For the design and production of complex systems, manufacturers are increasingly favoring design outsourcing to obtain external expertise and innovation. The inherent risk in design outsourcing, unlike traditional production outsourcing that caters to detailed specifications, stems from its incomplete contracting nature. This paper focuses on the transaction risk between customers and design contractors, which hampers both parties from benefitting from the contract and obtaining mutual benefits. Prototyping, commonly used for eliciting customer requirements and estimating manufacturing costs, is interpreted in this paper as a means of risk reduction and modeled via a Bayesian estimation process. A quantitative risk model is subsequently developed to investigate the investment decision upon prototyping, taking into consideration the fidelity and cost of the prototype. This paper provides a decision framework for practitioners to understand and manage transaction risks in the design outsourcing of complex systems.