Delegation vs. Control of Component Procurement Under Asymmetric Cost Information and Price-Only Contracts

A manufacturer must choose to delegate component procurement to its tier-1 supplier, or to control component procurement by contracting with both the tier-1 supplier and the tier-2 component supplier. Both suppliers have private cost information and the manufacturer has an alternative source of supply with cost known to all parties. This paper proves that if the firms may use arbitrarily complex contracts, then the manufacturer has the same expected profit with delegation as with control of component procurement. If, however, the firms use simple price-only contracts, then the manufacturer may achieve strictly greater expected profit with either delegation or control, depending upon the price of the alternative source, the selling price of the end product and, most importantly, what the manufacturer knows about her suppliers’ costs. A numerical study shows that over a wide range of conditions, if the manufacturer chooses delegation versus control correctly, then she achieves nearly as much expected profit with price-only contracts as with the complex optimal contracts. However, the study identifies conditions under which price-only contracts perform poorly, and also shows that the loss may be extremely high when the manufacturer chooses delegation versus control incorrectly.