Social Responsibility Auditing in Supply Chain Networks

We study a buyer's problem of auditing suppliers within an existing network to ensure social responsibility compliance. The buyer suffers economic damages if a violation at a supplier is exposed (whether by the media, regulator, or NGO). To avoid damages the buyer may audit the network to identify noncompliance. If a supplier fails an audit, the buyer must take one of two costly actions: either rectify the supplier or drop the supplier (along with any dependent suppliers). Dropping a supplier changes the network topology, reducing competition and thereby increasing the buyer's input cost arising from an equilibrium. We show the buyer's optimal dynamic auditing policy has two subphases: the buyer will first audit and drop some suppliers, before either auditing and rectifying all remaining suppliers, or halting auditing altogether. By halting, the buyer tolerates some noncompliance in the network ("see no evil, hear no evil"). Within the audit-and-drop subphase, when auditing only in the upper tier, the buyer always audits a least valuable unaudited supplier, yielding greater balance in the network. When the buyer audits both tiers, it might choose a supplier other than the least valuable. The buyer may choose a supplier in a pivotal position to help ascertain the viability of a portion of the network ("litmus test"). In extensions, we find: when violations in tier 1 carry higher penalty for the buyer, the buyer may audit and rectify only tier-1 suppliers; when audits may be inaccurate, the buyer more likely tolerates a greater level of noncompliance.