Delegation vs. direct sourcing revisited: contract types under correlated supply risks and asymmetric cost information

Jiguang Chena, He Xub & Pin Zhouc*a School of Management, Xiamen University, Xiamen, People's Republic of Chinab School of Management, Huazhong University of Science and Technology, Wuhan, People's Republic of Chinac School of Management, Wuhan University of Technology, Wuhan, People's Republic of China* Corresponding author. Email: zhoupin@hust.edu.cnAs a popular practice in purchasing, an ever-increasing number of upper-tier suppliers are being added in the supply base of the original equipment manufacturer (OEM) and leveraged to reduce supply risk. This new trend increases the OEM's opportunities to directly source from tier-2 suppliers (direct sourcing for better control) in addition to delegating tier-1 suppliers to source on behalf of the OEM itself (delegation). This paper is devoted to comparing these two mechanisms (delegation vs. direct souring) under both asymmetric information on the production costs of tier-2 suppliers and correlated supply disruptions with tier-2 suppliers. When the OEM offers a revenue-sharing term contract or a base-commitment term contract (in which the OEM is required to procure a fixed base quantity in addition to an option of procuring additional units at a pre-specified price) to a tier-1 supplier under delegation, delegation achieves the same profit for the OEM as direct sourcing does. However, under a fixed-quantity term contract, delegation achieves a lower profit for the OEM than direct sourcing does, no matter the CM is subject to the procurement budget constraint or deep pocket. Moreover, we find delegation may lead to a higher profit for the OEM than direct sourcing does if an improved fixed-quantity term contract is used under delegation with a deep-pocket CM.