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. However, such efforts are costly and often unobservable to the buyers. A common practice for inducing high-level supplier performance is to source from multiple suppliers and to strategically allocate business to such suppliers 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, which is generally not a simple rank-order tournament. The optimal scheme allocates business according to each supplier's performance relative to their respective optimal performance target, which 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.