Contracts for Changing Times: Sourcing with Raw Material Price Volatility and Information Asymmetry

We analyze and compare five contract schemes used in a supply chain: fixed price (FP), cost reimbursement (CR), procurement control (PC), index-linked payment (IL), and relational (RL) contracts. From interviews, we learned that (1) FP and RL are the two most popular schemes; (2) PC is less popular, but it is used more often than CR and IL; and (3) a couple of firms are considering CR and IL and will probably use them in the future. By presenting a two-stage contracting model that incorporates a risk-neutral buyer and a risk-averse supplier under raw material price uncertainty and information asymmetry, we show that overhedging the supplier's risk with an IL contract can be optimal for the buyer in many cases. Using the model to study the effects of price trends, risk attitudes, information asymmetry, and constraints on purchase time, we find that each contract can be optimal in certain situations from certain standpoints. In particular, when a long-term relationship is considered, RL is equivalent to IL as long as the contract is self-enforcing, and RL can replace IL when no index is available. Connecting the analytical results to the interviews, we find that firms' choices and considerations can be well understood.