Dynamic Cost Reduction Through Process Improvement in Assembly Networks

We consider a decentralized assembly system in which a buyer purchases components from several first-tier suppliers. We examine the dynamics of suppliers' investments in cost-reduction initiatives over the life cycle of a product under different procurement approaches. We model the suppliers' investment decisions under cost-contingent contracts, with wholesale prices determined on the basis of the prevailing component costs, as a dynamic game in closed-loop strategies. We show that there always exists an equilibrium in which the suppliers' investments are synchronized, that is, in each period either all suppliers invest in process improvement or no supplier does. We also consider target-price contracts, under which the assembler announces the rate of component cost reduction to be achieved over the product's life cycle at the beginning of the contractual relationship. We show that target-price contracts lead to higher investment levels and profits if the rates are properly specified. In general, the equilibrium investments of the suppliers are lower than those under centralized control. The buyer can eliminate this inefficiency by subsidizing a certain fraction of the costs of investments. We extend the model to a setting with two competing assemblers and knowledge spillover at the suppliers. We find that the level of inefficiency under decentralized control decreases with increased competition and spillover rate.