Withholding renewal of a supply agreement can be more powerful than other carrots and sticks
Boeing’s long-awaited 787 Dreamliner missed its first scheduled test flight in 2007 because of, among other problems, a shortage of bolts.
The lack of fasteners illustrates how the success of a sophisticated aircraft — each valued at hundreds of millions of dollars — can be held hostage when suppliers fail to deliver parts worth a few dollars each.
The problem isn’t unique to Boeing. Manufacturers of many high-tech products — medical imaging systems and the equipment used to make microchips, among others — are often dependent on a single supplier for critical components. When those suppliers fail to deliver enough parts when needed, costly delays and lost sales can follow.
Some standard supply contracts fail to prevent such shortages. They aren’t structured to give suppliers enough incentive to make investments in plants and equipment to meet the potential demand. As a solution, a paper published in European Journal of Operational Research proposes a contract that seeks to deepen the relationship between a high-tech manufacturer and suppliers and to provide strong incentives for suppliers to make investments required to meet demand that at times surges unexpectedly.
A Contingency Plan
Analysis by Eindhoven University of Technology’s Mirjam S. Meijer, Willem van Jaarsveld and Ton de Kok and UCLA Anderson’s Christopher S. Tang suggests that making contract renewal contingent on fulfilling the current agreement could encourage a supplier to invest in sufficient capacity. Such an arrangement would be more effective than commonly used contracts that are primarily based on unit price.
Such a contingent renewal contract encourages development of long-term relationships between a manufacturer and its suppliers. “Long-term collaborations are,” the authors write, “essential for the functioning of high-tech supply chains.”
Based on their work with ASML, a Netherlands-based maker of advanced extreme ultraviolet lithography systems used in making cutting-edge computer chips, the authors find that high-tech supply chains are different from those for mass-produced consumer goods.
- A new product can last for decades and go through multiple generations in order to make improvements and ultimately recoup initial research-and-development costs. Boeing’s 747, for instance, was introduced in 1970 and the last model — the 747-8 — ceased manufacturing in 2018.
- High-tech manufacturers encourage customers to place advance orders, but many buyers will wait until the first products come off the line. So total demand isn’t knowable ahead of time.
- Because of the uncertain demand, key suppliers, which have to invest in their plant, equipment and personnel, will generally insist on single-source contracts to mitigate the risks. That makes a manufacturer highly reliant on these suppliers.
- Manufacturers have limited insight into suppliers’ actual capacity until those suppliers deliver — or fail to do so.
Manufacturers can face high costs if critical parts are understocked, while suppliers will face excessive costs if they overinvest in production.
The authors’ proposed contract takes advantage of the fact that high-tech products go through multiple generations. In their discussions with ASML, the authors learned that supply contracts are typically renewed for each subsequent generation, but those arrangements are usually not spelled out. The researchers propose making nonrenewal of the contract an explicit penalty for nonperformance.
How Standard Contracts Fall Short
They compare the new contract with two common alternatives: a standard unit price contract, in which the manufacturer offers a price for the component and the supplier decides how much to invest in equipment and personnel to earn a profit; and a contract that imposes a financial penalty — either a lump-sum or per-unit charge — if the supplier fails to provide enough components to meet demand.
The standard unit price contract isn’t practical. Their analysis suggests that the supplier won’t invest as much as needed unless the manufacturer sacrifices some profit by paying a too-high price.
A contract that imposes a financial penalty for noncompliance can be effective, but it can also be unenforceable. If demand for the product is much greater than expected, the supplier’s penalty can quickly exceed its ability to pay.
Both contracts consider only a single generation. By looking at the long-term supplier relationship, the threat of nonrenewal creates an additional incentive for the supplier, which risks losing out on decades of lucrative sales. It would be willing to invest more in current capacity to reduce the risk of losing the relationship.
Based on a hypothetical example, the authors estimate that a manufacturer could earn 20% higher profits from increased sales enabled by the reliable delivery of components via their proposed contract than with the standard wholesale agreement.
Their analysis suggests that manufacturers would do well to seek out suppliers that have a long-term focus, which the contract will help to identify. The policy also needs to be made explicit, either in the contract or through clear communication between the manufacturer and the supplier.
UCLA Distinguished Professor; Edward W. Carter Chair in Business Administration; Senior Associate Dean, Global Initiatives; Faculty Director, Center for Global Management
About the Research
Meijer, M. S., van Jaarsveld, W., de Kok, T., & Tang, C. S. (2022). Direct versus indirect penalties for supply contracts in high-tech industry. European Journal of Operational Research, 301(1), 203–216. https://doi.org/10.1016/j.ejor.2021.10.009