Performance measurement and design in supply chains

This paper examines the relationship between product architecture, supply-chain performance metrics, and supply-chain efficiency. We model the contracting relationship between a supplier and a buyer. The supplier is privately informed about the outcome of his design/production investment. The buyer both appraises the supplier's component and does further processing/component production of his own. If the final product produced by the buyer exhibits decoupling and no function sharing with respect to the components (termed separable architecture), the first-best outcome is attained if both internal and external failures are contractible. When only one type of failure can be contracted on, we derive conditions under which contracting on internal failure is superior to contracting on external failure, and vice versa. If the buyer's final product has a nonseparable architecture with respect to the components, first-best cannot be achieved even if both internal and external failures are contractible. The value of contracting on internal failure alone is unaffected by the architecture design, while that of external failure declines relative to the separable setting; the net result is often to make the former the uniformly dominant performance metric. Our results highlight the interaction between the performance metrics used for contracting within the supply chain, the architecture of the product produced by the supply chain, and the incentive efficiency of the chain.