Volume Incentive Through Performance-based Allocation of Business

Buyers want their suppliers to make efforts to improve performance in the delivery of products and services, but the effort is costly and often unobservable to the buyers. A common practice for inducing high-level supplier performance is to source from multiple suppliers and strategically allocate business based on their past performance. To investigate the design of such performance-based volume incentive schemes, we consider a buyer’s dual sourcing problem in a dynamic principal-agent setting. We find that, to maximize suppliers’ competition over time, the optimal allocation scheme should involve the suppliers’ current shares of business and is generally not a simple rankorder tournament or winner-take-all allocation. The optimal scheme allocates business according to each supplier’s performance relative to their respective optimal performance target, and may not reward the better performer a larger share. A simple way to achieve near-optimal results is the use of "handicapped rules" that can significantly outperform simple first-past-the-post rules.