Incorporating Cost Risk in Supplier Selection for Long Term Contracts

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.