Incorporating Cost Risk in Supplier Selection for Long Term Contracts

Robert R. Inman and Maya Bam

The Engineering Economist, 2024, vol. 69, issue 3, 164-188

Abstract: Purchasing firms naturally select the supplier with the lowest total cost. Often overlooked is the impact of the duration of long-term contracts (common in the automotive industry). We provide a method to quantify how risk escalates with contract duration. Our method applies to virtually all cost elements. For clarity, we demonstrate it on logistics costs that can change over a long horizon, resulting in a change in the relative attractiveness of candidate suppliers. We simulate a case study to estimate the likelihood that each supplier will provide the lowest cost over the contract duration. Finally, we quantify the risk reduction afforded by dividing a long contract into a sequence of shorter contracts.

Date: 2024
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DOI: 10.1080/0013791X.2024.2367198

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