Audit and Compliance in Supply Chains with Damage Cost Sharing under Supplier's Responsibility Standards
30 Pages Posted: 10 Oct 2022
Date Written: October 6, 2022
Problem definition: To guarantee a responsible supply chain, there are governmental regulations or industry standard that suppliers have to adhere to. A supplier is primarily responsible for the cost to follow these standards, and if any violation occurs, the damage cost mostly falls onto the buyer. This leads to incentive misalignment between a buyer and a supplier. While audits are “proactive safeguards” that a buyer can use to incentivize its supplier to comply with the standards, a “reactive safeguard” includes the buyer to hold a non-compliant supplier (partially) accountable for the damage occurred due to the latter’s non-compliance. Our work contributes to the literature on responsible supply chains by analyzing the interplay between buyer audits and supplier compliance when damages due to non-compliance are borne by both buyer and supplier, in the presence of pre-committed compliance standards.
Methodology/results: We develop a multi-buyer-single-supplier game-theoretic model, where supplier decides its compliance to the industry standard, and each buyer determines its audit level. The supplier is liable to a fraction of the damage cost if it under-complies. We find that the supplier would choose to be less compliant whenever buyers audit stringently. Moreover, under-compliance occurs if the standard is low and the buyers’ audit costs are low. Next, joint audits, where all buyers collectively audit the supplier and share the audit and risk-mitigation costs among themselves, can aggravate supplier’s under-compliance. However, shared audits, wherein each buyer independently audits the supplier but shares its audit information with all other buyers, can improve supplier’s compliance, especially when the compliance standard is low. Finally, our results also show that supplier’s profit is higher in joint audit than in independent audit, whereas the buyers’ profits are highest under the audit scheme where their audit level is sufficiently high vis-`a-vis the other schemes.
Managerial implications: While sharing damages can potentially compensate for a decrease in buyers’ audits, more stringent audits when sharing damages may backfire by degrading supplier’s compliance. Furthermore, in the presence of damage sharing, while compliance standard substitutes for buyers’ audits, it complements supplier’s compliance.
Keywords: supply chain risk, compliance standards, buyer audits, supplier compliance, supplier under-compliance, socially responsible operations
Suggested Citation: Suggested Citation