Supply Chain Contracting: Non-Recurring Engineering Charge, Minimum Order Quantity, and Boilerplate Contracts

This paper develops a contracting model in which a supplier and a buyer have an opportunity to enter a long-term supply relationship. The buyer knows whether the market for his new product is either large or small, but the supplier can only make an assessment of the probabilities. We derive and characterize the optimal contractual forms from the supplier’s perspective. The optimal offering of the supplier (to the buyer) is one of the following three forms: (1) a customized menu (which depends on the supplier’s probability assessment) that will always lead to a signed contract (by the buyer regardless of his market size), (2) a boilerplate contract (which is independent of the assessment) that will be signed only if the buyer’s market is large, or (3) a boilerplate menu that will always lead to a signed contract. The optimal contractual form helps explain the practice of setup (or non-recurring engineering) charge, minimum order quantity (with a buyback option), and boilerplate contracts. The menus enable the buyer to signal his market size to the supplier in a credible way and induce the supplier to build the corresponding capacity.