Sourcing Under Supplier Responsibility Risk: The Effects of Certification, Audit and Contingency Payment

Companies that source from emerging economies often face supplier responsibility risks, namely, financial and reputational burdens that the companies have to bear when their suppliers' engagement in noncomplying labor and environmental practices is discovered by stakeholders or becomes public. To mitigate such risks, companies can invest in screening mechanisms and can design incentive schemes in sourcing contracts. However, the relative effectiveness of these actions is often not known. To address this problem, we develop a model that captures the economic tradeoffs faced by the supplier when committing a violation. The endogenized noncompliance probability can be influenced by various factors, including the supplier's intrinsic ethical level, which may not be observable to the buyer. We then consider the buyer's sourcing problem under such risks. We find that, when the buyer anticipates incurring a high cost due to supplier responsibility problems, it is generally ineffective to design incentive-compatible contracts to achieve “economic screening of different supplier types — instead, a single contract to all types (i.e., a pooling contract) is optimal. On the other hand, “physical screening by supplier certification, if designed properly, can be an effective solution to separate the supplier types and achieve lower sourcing costs. When certification is combined with audit and contingency payment, contracting exclusively with the certified supplier is optimal under certain conditions. These findings provide explanations for some of the observed practices used in industry to mitigate supplier responsibility risks.