Procurement policy and supplier behavior-OEM vs. ODM

Procurement policy and supplier behavior-OEM vs. ODM

Chang, Chiaho

This paper has two purposes. The first one is to describe and contrast the cost-reducing efforts of original equipment manufacturing (OEM) and original design manufacturing (ODM) suppliers given a fixed, cost-plus contract. The result shows that the cost-reducing effort ofthe OEM supplier is in line with the assembler s requirement while the ODM supplier is able to keep some of the information rent and exerts less effort. The bargaining power of the ODM supplier is also stronger relative to that of the OEM supplier. It is consistent with the degree of information asymmetry residing in the contracting parties. The second purpose is to derive an optimal contract and procurement policy based on a simple institutional setting. The optimal cost-plus contract is obtained and its components deciphered. The drivers behind the supplier s cost-reducing effort are also studied.

Outsourcing is the strategic use of outside resources to perform activities traditionally handled by internal staff and resources.’ It has been practiced for years, but the recent surge in excitement and growth is likely to result from changes in the competitive marketplace, which force the companies to take a hard look at their core competencies and to form a closer alliance with their suppliers to help reduce costs and improve services. Supply chain management, as part of the enterprise resource planning (ERP) paradigm, becomes critical for survival.2

The success of the Japanese auto makers has generated significant interest for researchers to look into many aspects of the Japanese style of management. On the operational side, important concepts in Japanese production systems such as the kanban system, zero inventory, and just-in-time have been formalized and heavily studied (e.g., Monden 1983; Hall & Hall 1984). This development has also ignited research in analyzing the impact of setup cost reduction on production planning (e.g., Porteus, 1985; Zangwill, 1987). When US manufacturers encountered difficulties in implementing kanban or just-in-time systems, researchers began to study the behavioral side of the Japanese system, especially corporate culture such as business groups and keiretsu, lifetime employment, and team work (e.g., Hutchins, 1986; Abegglen & Stalk, 1985; Imai, 1986). However, when it comes to one of the building blocks of the Japanese auto industry, the suppliers, the incentive issues as applied to the relationship between the assembler and its suppliers receive little attention.

One major reason is that the data are difficult to come by. Researchers are not able to obtain the details of contract negotiations and the finalized version of the contract itself. Even if they are familiar with the operations, the research methodology used is based on case-bycase, descriptive field studies, which are difficult to generalize. Second, even written contracts sometimes are vague. Informal, implicit agreements constitute a large portion of these blackbox elements. Third, most researchers in this area come from disciplines such as operations research, industrial engineering, management science, and organizational behavior, which usually regard such supplier relationship as being smooth, thereby assuming away the incentive problems. Economists are indeed interested in optimal incentive schemes. However, their derivations are usually done without taking into account what practice dictates, a criticism rightfully advanced by Arrow (1985).

Asanuma (1985a, 1989) has conducted extensive field studies in the Japanese auto industry.’ Three sources of components were identified: (1) design supplied (DS), where the assembler provides the technical drawings and the supplier provides only the manufacturing capability; 2) design approved (DA), where the supplier provides both the manufacturing capability and technical know-how for the design approved by the assembler; and (3) off the shelf(OS) For standard components. In the realm of supply chain management, the assembler is most interested in the first two sources, which will be called OEM (original equipment manufacturing) and ODM (original design manufacturing) in this paper for generality.

This paper describes and contrasts the cost-reducing efforts of the OEM and ODM suppliers given a fixed, cost-plus contract. Reducing and controlling operating costs is listed as the top reason companies outsource.4 As the practice of target costing spreads rapidly, the assembler has every intention of “transmit[ting] the competitive reality faced by the firm to its suppliers” (Cooper & Slagmulder, 1997, p. 14). How the suppliers react to the assembler’s demand and whether there is any difference among suppliers become interesting issues. In addition, this research derives an optimal contract and procurement policy based on a simple institutional setting in order to address the incentive issues involved in observed Japanese practice of adopting linear contracts (Asanuma, 1985a) in such relationships.

The remainder of the paper is organized as follows. The next section provides a literature review on related issues. This is followed by an analysis of the supplier behavior given a fixed, cost-plus contract, as well as the derivation of the optimal procurement policy. The last section concludes the paper.


Although target costing is usually classified as one form of market-based pricing,’ its value as a cost-reducing tool cannot be overemphasized. Once set, “[t]he target cost ofa product can never be exceeded. “6 The firm then uses techniques such as value engineering and quality function deployment to modify design, material specification and production process to reduce costs while preserving the value as perceived by the customers. For outsourced components, the assembler transmits the market pressure to the supplier in the form of target price paid, which in turn becomes the supplier’s target cost to meet.

Loeb and Surysekar (1998) studied whether and how payment ceilings should be set in costplus contracting. Their findings support the use of an overall payment ceiling to elicit the supplier’s private (cost) information and to mitigate the moral hazard problem associated with cost-plus contracting. However, when target costing paradigm is adopted, as is done in this paper, both “whether” and “how” problems with respect to payment ceilings become moot at best. The ceiling is already determined by the market conditions.

Laffont and Tirole (1986) considered a static (one-period) control problem where a regulated firm with private information about its own efficiency parameter decides what level of effort to put into the production process. The regulator (e.g., the government agency) has a prior belief of the firm’s “type” and observes the actual cost of production. They are able to derive an optimal scheme which is linear in ex post cost. See Holmstrom and Milgrom (1987) for similar results.

In Laffont and Tirole (1988), the authors preserved most of the basic structure of their 1986 paper, including the efficiency parameter, but extended it to a dynamic (two-period) framework. This paper formalizes the concept of “ratchet effect “‘ by allowing the regulator not to “commit himself not to use in the second period the information conveyed by the firm’s first-period performance. ”

The problem with the use of the efficiency parameter to identify the type of the firm is that when there are more than two periods, as the models in this paper adopt, it becomes difficult to update the regulator’s belief reasonably well unless an appropriate equilibrium concept is invoked, such as a sequential equilibrium (Kreps & Wilson, 1982), an exercise not tried here. Instead, the efficiency parameter is replaced by a random variable that represents the unpredictable production environment (e.g., how likely the machinery will break down or the yield rate of the output) against which the supplier exerts effort to tame the cost of production. The realization of this random variable is observable only by the supplier before she makes an effort decision but the assembler has some preliminary information about it (i.e., knows its probability distribution).

Another problem with Laffont and Tirole (1988) is that although a two-period model provides sharper focus and tractability, it simply cannot capture the long-term relation between the assembler and his suppliers. The multi-period models presented in this paper thus subsume the two-period one and eventually are extended to infinite horizon.

The cost structure used in this paper is similar to that of McAfee and McMillan (1986) with two differences. First, it is indexed by time in a multi-period setting; second, the target cost at period t replaces the intrinsic cost that is observable only by the supplier. They also compare an incentive contract with cost-plus and fixed-price contracts8 in a bidding situation and conclude that the incentive contract performs better. Since their model is essentially one-period,9 target cost plays no role except in the trivial case where average cost is calculated from previous periods. Kawasaki and McMillan (1987) used their results to empirically examine the parameters of the incentive contract in the context of subcontracting in Japanese manufacturing industries.” It is tempting to use the incentive contract because of strong empirical implications. But as Asanuma (1985a) points out, the contracts between the assembler and his suppliers are basically cost-plus. So the efficiency issue of the incentive contract will be put aside for future studies

As to the ratchet effect, Weitzman (1980) provides an early treatment on this topic. He models a no-commitment situation by explicitly formulating target output as a function of the agent’s previous performance, as is done in this paper. But he treats the parameters of the target as random variables. Instead, this paper leaves these parameters fixed, as is determined in the negotiation process before mass production begins, so the bargaining power of the parties to the contract can be examined.

Recent development in the literature casts the issue of specific investment (or reliance investment in contract law jargon), such as the cost-reducing effort in this paper, in the realm of incomplete contracts and renegotiation (e.g., Chung, 1991; Hart & Moore, 1988; Reichelstein, 1992). Gietzmann and Larsen (1998) analyzed how cooperation between the assembler and the supplier can be achieved via a careful design of the governance procedures in an incomplete contract setting. Since the parameters of the contract considered in the model are assumed fixed ex ante, such complexity is avoided.


The solution to (A-OEM) says nothing about lambda, with respect to the ODM supplier. Presumably, it should be higher than that for the ODM supplier to bring the OEM supplier in line with the assembler’s policy. It can be called a “carrot-and-stick” approach toward the OEM supplier.

On the other hand, since these parameters are determined ex ante during the negotiation process before mass production begins, this scheme calls for more bargaining power for the ODM supplier as opposed to the OEM supplier, relative to that of the assembler. This may be called a “honey-and-sugar” policy for the ODM supplier.

It seems paradoxical at first to compare the results of Propositions 1 and 2 because the OEM

supplier receives H^sub t^ (alpha^sub t^^sup OEM^) = alpha = 1 while the ODM supplier receives H^sub t^(alpha^sub t^^sup ODM^)

implying that the OEM supplier may be given a better bargaining position in terms of a. In fact, the larger share of (relation-specific) investment gain paid to the OEM supplier can be interpreted as merit from the assembler and his intention to cultivate the OEM supplier, who is more vulnerable, rather than an expression of larger bargaining power on the part of the OEM supplier.


The detailed contractual relationship between the assembler and the supplier will be studied in this section. Figure 2 presents the sequence of the procurement process used.

In his procurement policy, the assembler specifies x units of a particular component for trial production and z units of projected demand for mass production by the designated supplier, if this stage is ever reached. The supplier realizes the unit cost of c during trial production and reports c instead.

Unit compensation is a function of the reported cost, s = s(Z) and is agreed upon beforehand. It is assumed that s is increasing in Z . The assembler has a procurement target cost, CT , that he is willing to pay for each unit of the component acquired. This target cost is determined by considering competitive price in the market and his own desired target profit and is given exogenously in the model.


When confronted with increasing pressure to lower costs, a utility maximizing supplier will react to the assembler’s contract offer with corresponding level of cost-reducing effort exerted, given that the contract is accepted. However, different types of suppliers are expected to react differently. Considering the Japanese automotive industry in particular and manufacturing businesses in general as the backdrop, this paper compares the behavior of the OEM and the ODM suppliers in the presence of a fixed, cost-plus contract. The different degrees of information asymmetry between the assembler and the two suppliers lead the former to have complete control over the OEM supplier’s cost-reducing effort while leaving the ODM supplier room for information rent. The issue of bargaining power between contracting parties is also explored.

The contractual scheme is then relaxed to derive an optimal procurement policy for the assembler. It turns out to be a linear one, the transfer payment to the supplier consisting of net production cost (i.e., production cost net of savings from cost-reducing effort) plus compensation for the costs of cost-reducing effort and part of the fixed assets purchased for the project. The result also demonstrates the potential to implement a lagged price adjustment mechanism in which the supplier enjoys additional cost savings once the target cost has been met during the current contract period. In other words, the extra savings from the supplier’s cost-reducing effort will not be exploited by the assembler until the next round of contract negotiation begins, in which a new (and lower) target cost will be set. The assembler is encouraged to foster a closer tie with the supplier through longer-term relationship building, providing technical and technological assistance, and even arranging lower-cost loans for the supplier in exchange for the latter’s willingness to reduce costs further. The assembler will be better able to share market pressure with his network of suppliers and concentrate on improving products and services.

Two limitations to the modeling approach here can be relaxed or amended in future research. The assembler’s target procurement cost plays a crucial role in determining the fate of the mass production stage and the project as a whole, but it is given exogenously. It would be better if this target cost can be determined as a decision variable in the model. Also, the model entails essentially one big period, leaving price adjustment incomplete and the assembler’s role passive. Extending the model to one more period will infuse richer results.


The author would like to thank an anonymous reviewer and the participants of 30″ WDSI annual meeting for their invaluable comments and suggestions.

1. See the Outsourcing Institute’s web site at

2. See, for example, Davis et al. (1998), Christopher (1998) and Simchi-Levi et al. (2000). 3. See also Gietzmann & Larsen (1998).

4. Survey of current and potential outsourcing end-users (The Outsourcing Institute Membership, 1998).

5. See, for example, Horngren, Foster & Datar (2000). 6. Cooper & Slagmulder (1997).

7. “An agent with a high performance today will tomorrow face a demanding incentive scheme. He should thus be reluctant to convey favorable information early in the relationship. ” (Laffont & Tirole 1988)

8. Let p = b + a (c – b) be the unit price for a component, where b is the target price including negotiated profit margin and c the realized average cost preceding the price revision. If the sharing parameter a is zero, the contract is set at a fixed price. If a is one, the contract is cost-plus. If 0

9. It will be interesting to see which contract form (i.e., incentive, fixed-price, or cost-plus) fares better in multi-period setting.

10. The industries included in their paper are textiles, clothing, iron and steel, nonferrous metals, metal products, machinery, electrical machinery and equipment, transportation equipment, and precision instruments. Some of them are related to the auto industry.

11. See Laffont & Tirole (1988).

12. Imagine that both the assembler and the ODM supplier determine the target infinitely often during the whole contract periods.

13. “Citizen Watch demands its suppliers decrease their costs a minimum of 3 percent per year. This 3 percent decrease in cost is included in the budget. Suppliers keep any cost saving in excess of 3 percent [emphasis added] ” (Blocher, Chen & Lin, 1999, citing Cooper (1993)).

14. The timing differences may distinguish various types of sourcing schemes in the literature. In dual or multiple sourcing, the assembler sources from two or more suppliers at the same time. See Klotz & Chatterjee (1995) and Seshadri, Chatterjee & Lilien (1991). In second sourcing, the assembler allows a supplier to trial produce for some time, and then asks her to share technology with a second supplier, who will later compete with the first supplier in the reprocurement stage. See Anton & Yao (1987), Demski, Sappington & Spiller (1987), Farrell & Gallini (1988), and Riordan & Sappington (1989).


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Chiaho Chang, Montclair State University

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