Value of Audit for Supply Chains with Hidden Action and Information

Highlights

Despite the many benefits of outsourcing, firms are still concerned about the lack of critical information regarding both the risk levels and actions of their suppliers in distant locations. Addressing these concerns, two opposite approaches emerge among the supply chain companies. At one extreme is the so-called "arms-length relationship" approach, which advocates incentivizing suppliers by delaying the payment after checking the delivery outcome. At the other extreme is the "close relationship" approach, in which the manufacturers work closely with their suppliers, monitor their actions at the beginning of the production process, and furthermore link the incentives to the actions taken at the source. For example, Apple Inc. owns its success to its extensive contract-based outsourcing along with a very strong auditing program. In just 2018 alone, Apple completed 770 managed supplier assessments covering manufacturing facilities, logistics and repair centers, and contact center facilities. This paper characterizes the value of auditing supplier’s action when choosing between the above two opposite approaches.