Financing a Sustainable Supply Chain

Abstract

Problem Definition: We study the effects of financing on supply chain sustainability. Academic/Practical Relevance: In recent years, companies have increasingly used supply chain financing---as a replacement of bank financing---to engage their financially constrained suppliers. Our study is among the first in the supply chain literature to investigate the relative effectiveness of different financing mechanisms in support of supply chain sustainability. Methodology: We consider a decentralized supply chain where a buyer sources from a financially constrained supplier. The supplier borrows from either a bank or the buyer to finance his production. The buyer audits the supplier for sustainability compliance and will accept and pay for the orders only if the supplier passes the audit. Results: We find that under conventional bank financing, the bank that is concerned with the supplier's audit failure will raise the interest rate as the value of the supplier's collateral decreases. This not only hinders the supplier's compliance effort but also hurts the profitability of every stakeholder. In contrast, under buyer financing, the buyer may leverage financing to improve sustainability by offering the supplier a low interest rate. This occurs when the supplier's collateral is of low value. However, if the supplier's collateral is of high value, under buyer financing, the buyer may be tempted to set a high interest rate to exploit the supplier, which reduces both the supplier's compliance level and the supply chain profitability. Managerial Implications: Our findings suggest that buyer financing may not always be an effective approach for encouraging supply chain sustainability. As such, we propose an alternative mechanism under which the buyer offers a reward to the supplier if he passes the audit while the supplier continues to borrow from a bank. We demonstrate that such a bank financing plus audit reward scheme both induces a higher sustainability compliance level and increases total supply chain profitability. Interestingly, it is more effective than buyer financing (even with similar audit reward) for sustainability especially when the supplier's collateral is of low value.