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 becomes public. To mitigate such risks, companies can invest in screening mechanisms and design incentive schemes in sourcing contracts. Common mitigation instruments include supplier certification, process audits, and contingency payments. The interactions of these instruments are often not well understood. We first note that the effectiveness of any mitigation instrument depends on how it changes the economic trade-offs faced by a supplier in compliance to social and environmental standard, and hence we develop a model that explicitly captures such trade-offs. As a result, our model endogenizes the supplier’s noncompliance probability and connects it with various factors, including the supplier’s intrinsic ethical level that is unobservable to the buyer. We then study the buyer’s optimal contracting problem under different mitigation instruments. We find that although the process audit and contingency payment instruments can directly lower supplier responsibility risk, they, acting alone, are not as effective as the supplier certification instrument in screening suppliers with different ethical levels. Nevertheless, these instruments are all complementary to each other; when used jointly, they make supplier screening more effective and result in lower sourcing cost. These findings provide explanations for some of the observed practices used in industry to mitigate supplier responsibility risks.