The Role of Contract Negotiation and Industry Structure in Production Outsourcing

Production and Operations Management, 22(5) 1299-1399.

21 Pages Posted: 17 Oct 2012 Last revised: 11 Jan 2017

See all articles by Qi Feng

Qi Feng

Purdue University - Krannert School of Management

Lauren Xiaoyuan Lu

Dartmouth College - Tuck School of Business

Date Written: 2013

Abstract

Despite the widespread of cost-driven outsourcing practices, academic research cautions that suppliers' cost advantage may weaken manufacturers' bargaining positions in negotiating outsourcing agreements, thereby hurting their profitability. In this paper, we attempt to further understand the strategic impact of low cost outsourcing on manufacturers' profitability by investigating the contractual form of outsourcing agreements and the industry structure of the upstream supply market. We consider a two-tier supply chain system, consisting of two competing manufacturers, who have the option to produce in-house or to outsource to an upstream supplier with lower cost. To reach an outsourcing agreement, each manufacturer engages in bilateral negotiation with her supplier, who may be an exclusive supplier or a common supplier serving both manufacturers. Our analysis shows that wholesale-price contracts always mitigate the competition between manufacturers regardless of whether they compete with price or quantity. In contrast, two-part tariffs intensify the competition when the manufacturers compete with quantity, but soften it when they compete with price. As a result, when outsourcing with two-part tariffs, the manufacturers may earn lower profits than they would from in-house production, although the suppliers are more cost efficient. This suggests that managers have to be wary about the downside of using coordinating contracts such as two-part tariffs when pursuing low-cost outsourcing strategies. Our analysis also sheds some light on the profitability of using an exclusive supplier for outsourcing. When outsourcing with wholesale-price contracts, the competing manufacturers are better off outsourcing to an exclusive supplier. However, when outsourcing with two-part tariffs, the manufacturers may earn higher profits by outsourcing to a common supplier than to an exclusive one when the manufacturers' bargaining power is sufficiently strong (weak) under quantity (price) competition.

Keywords: outsourcing, wholesale-price contract, two-part tariff, multiunit bilateral bargaining

Suggested Citation

Feng, Qi and Lu, Lauren Xiaoyuan, The Role of Contract Negotiation and Industry Structure in Production Outsourcing (2013). Production and Operations Management, 22(5) 1299-1399., Available at SSRN: https://ssrn.com/abstract=2162301

Qi Feng

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

Lauren Xiaoyuan Lu (Contact Author)

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

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