Inducing high service capacities in outsourcing via penalty and competition

In this article, we consider a model of multiple make-to-order suppliers, which compete based on their promised sojourn times. A fixed penalty is imposed on the suppliers for failing the promised delivery time requirement at an agreed service level. The demand is allocated to the suppliers according to the promised sojourn times, using either supplier-selection (SS) approach or supplier-allocation (SA) approach as proposed in Benjaafar et al. (2007, Outsourcing via service competition, Management Science, 53 (2), 241-259). Their framework and results are then applied to obtain the competition outcome. It was found that the buyer can orchestrate the competition to induce the suppliers to offer lower promised sojourn times and select higher service capacities through restricting the suppliers to choose promised sojourn times above a certain level. The SS approach is also found to induce a better service quality than the SA approach. The role of the penalty level is then addressed. It was found that a higher penalty level induces a higher service capacity and is always beneficial to the buyer.