A Comparison of Two Sourcing Mechanisms: Two-Stage Sourcing Process and Performance-Based Contracting

This paper considers the problem faced by a manufacturer who outsources the production of a product to one or more competing suppliers, who differ in their cost structures, as well as in their capabilities for producing high quality products. The manufacturer's problem is to design the sourcing process to enhance profitability by ensuring that the selected supplier has sufficient quality capability, while at the same time encouraging competition among the potential suppliers in order to reduce procurement costs. We develop and analyze mathematical models of a two alternative sourcing processes (a two-stage sourcing process and performance-based contracting) that are appropriate when the manufacturer has imperfect information regarding the suppliers' costs and capabilities. We use these models to compare the performance of these two processes from the perspectives of the buyer, the supplier and the system as a while, and to develop strategic insights regarding the relative performance of the two alternative mechanisms. The theoretical results and managerial insights derived from this research can enable manufacturing firms to improve the management of their sourcing processes.