Should an OEM Retain Sourcing When the CM Produces Competing Products?

Abstract

We consider a powerful original equipment manufacturer (OEM) who relies on a contract manufacturer (CM) to produce her product. In addition to the OEM's product, the CM also produces for a less powerful OEM. The two products not only are engaged in Cournot competition in the consumer market, but also require a common critical component. Both the powerful OEM and the CM can purchase the component from the supplier. However, their purchase prices may differ and are unknown to each other. The less powerful OEM has to rely on the CM to procurement components for her. The main question we address is whether the powerful OEM should retain sourcing by purchasing component from the supplier and reselling to the CM (buy-sell), or outsource sourcing by letting the CM purchase directly from the supplier (turnkey). We show that, under buy-sell, the powerful OEM's optimal strategy is to resell components at the highest possible component purchase price of the CM (i.e., the street price). This result of masking price to the street price is consistent with recent industry practices by HP and Motorola. Our comparison between buy-sell and turnkey provides some interesting insights. A CM with low component price is better off under turnkey, despite the fact that under buy-sell, he receives more profit through the products sold to the less powerful OEM. The OEM's preference between buy-sell and turnkey depends on her component price, the volatility of the CM's component price and substitutability between the two products. Our analytic results indicate that an OEM with low component price is better off under buy-sell.