Direct sourcing or agent sourcing? Contract negotiation in procurement outsourcing

Problem definition: In a supply network consisting of a buyer, a purchasing agent, and a supplier, the buyer can procure the component from the supplier directly and rely on the purchasing agent for complementary services (named direct sourcing (DS)) or authorize the purchasing agent to conduct both procurement and complementary services (named agent sourcing (AS)). When parties bargain pairwisely, how do their bargaining powers influence the equilibrium procurement outsourcing structure? Academic/practical relevance: Both outsourcing structures, DS and AS are commonly observed in practice, whereas the literature has rarely answered the questions that we ask. Methodology: We adopt the generalized Nash bargaining framework to model the negotiations among the parties and derive the corresponding equilibrium outcomes under both outsourcing structures by taking into consideration the existence of a component spot market. Results: When two parties negotiate directly, we define their direct negotiation coefficient as the ratio of their exogenous bilateral relative bargaining powers. If they negotiate indirectly through a third party, we define their indirect negotiation coefficient as the quotient of their respective direct negotiation coefficients with respect to the third party. We show that when parties negotiate over both wholesale prices and quantities, the buyer s preference for DS and AS solely depends on the comparison result of the buyer s direct negotiation coefficient versus the indirect one with respect to the supplier. When the quantity is determined by the buyer and parties negotiate over wholesale prices, the equilibrium outsourcing structure hinges critically upon the magnitude of the purchasing agent s relative bargaining power over the supplier. Interestingly, the preferences of the three parties for DS and AS may be aligned with each other. We also show that it is in the best interest of the buyer to negotiate prices only. Managerial implications: Our research identifies the endogenous bargaining powers among parties that dictate the equilibrium outsourcing structure. It indicates that the buyer needs to adjust procurement outsourcing decisions accordingly when the bargaining powers of the buyer s upstream partners are altered, especially when the buyer s bargaining power is sufficiently large: we analytically show that the buyer s preference is very sensitive to the relative bargaining powers of the purchasing agent and the supplier. This might help explain why Walmart switched from AS with Li & Fung to DS within just three years.