Managing Opportunistic Supplier Product Adulteration: Deferred Payments, Inspection, and Combined Mechanisms

Abstract

Recent cases of product adulteration by foreign suppliers have compelled many manufacturers to re-think approaches to deterring suppliers from cutting corners, especially when manufacturers cannot fully monitor and control the suppliers' actions. Recognizing that process certification programs, such as ISO9000, do not guarantee unadulterated products and that product liability and product warranty with foreign suppliers are rarely enforceable, manufacturers turn to mechanisms that make payments to the suppliers contingent on no defects discovery. In this paper we study: (a) the deferred payment mechanism -the buyer pays the supplier after the deferred payment period only if no adulteration has been discovered by the customers; (b) the inspection mechanism -the buyer pays the supplier is immediately, contingent on product passing the inspection; and (c) the combined mechanism -a combination of the deferred payment and inspection mechanisms. We find the optimal contracts for each mechanism, and describe the Nash equilibria of inspection sub-games for the inspection and the combined mechanisms. The inspection mechanism cannot completely deter the suppliers from product adulteration, while the deferred payment mechanism can. Surprisingly, the combined mechanism is redundant: either the inspection or the deferred payment mechanisms perform just as well. Finally, the four factors that determine the dominance of deferred payment mechanism over the inspection mechanism are: (a) the inspection cost relative to inspection accuracy, (b) the buyer's liability for adulterated products, (c) the difference in financing rates for the buyer and the supplier relative to the defects discovery rate by customers, and (d) the difference in production costs for adulterated and unadulterated product.

Decentralized Supply Risk Management

“…Wan and Beil (2009) consider asymmetric information about suppliers' production cost. Babich and Tang (2010) study asymmetric information about a supplier's actions to adulterate products. A detailed description of asymmetric information and supply risk models is provided in Section 6.…”

“…Babich and Tang (2010) investigate the use of payments contingent on favorable inspection outcomes or customers not discovering product defects over a pre-specified period in inspection, deferred payment, and combined mechanisms.…”

“…In Babich and Tang (2010), it is asymmetric information about the supplier's potential action to adulterate the product that creates supply risk for the buyer in the first place. As numerous recent examples of product recalls show, when buyers cannot monitor their overseas suppliers, those suppliers, under tremendous pressure to cut cost, are tempted to compromise on quality.…”

“…Supplier liability and warranties are difficult to enforce with overseas suppliers, who are subject to different legal systems, and frequently do not have resources to compensate the buyer for the losses. An approach that seems promising and that is studied in Babich and Tang (2010) is the deferred payment mechanism, when the buyer defers the payment to the supplier for a pre-specified period, and pays contingent on the customers not discovering defects. An example of a deferred payment mechanism is a popular financial contract, called trade credit.…”

OM Forum—Three Simple Approaches for Young Scholars to Identify Relevant and Novel Research Topics in Operations Management

“…Was it due to changes in regulations/government policies (e.g., recycling legislation (Atasu and Subramanian 2012)), changes in competition landscape/consumer preferences (e.g., speed and quality competition (Li et al 2016)), technological disruptions (e.g., innovative business models (Girotra and Netessine 2014)), or manmade/natural disruptions (e.g., disaster relief operations (Starr and van Wassenhove 2014)), and product adulteration (Babich and Tang 2012)? Without asking enough "whys," we undermine the possibility of discovering new research ideas.…”