Contracting a Development Supplier in the Face of a Cost-Competitive Second Source of Supply

The development of important components for a new product is frequently outsourced to suppliers. As this transfers a major opportunity to determine the component’s production cost to the development supplier, the manufacturer has to ensure that the supplier makes an effort to keep production costs low. During the production phase, the development supplier is not necessarily the source of supply, since there may be other suppliers who can produce the component at a lower cost. The challenge for the manufacturer is to choose a sourcing strategy that allows to profit from the cost advantage of these suppliers while making sure that the cost reduction potential during component development is exploited as well. Building on an analytical model of the supply chain, we compare various sourcing and contracting strategies with respect to their ability to resolve this tradeoff. The results suggest that dual sourcing with a combined wholesale price and licensing agreement or single sourcing with subcontracting dominate various other strategies. We reflect our findings in view of several real-world development and supply agreements.