Sourcing Innovation: Integrated System or Individual Components?

Abstract

Problem definition: Most industrial innovations consist of multiple interacting components that must be combined into a final product to form an integrated system. When procuring such complex innovations from their suppliers, buyers face a substantial challenge: Should they tender the integrated system as a whole or, instead, procure the system’s components individually from (possibly) different suppliers? Academic/practical relevance: Suppliers have become a major source of innovation for many firms, so buyers ponder how best to structure their procurement efforts. This paper offers guidance on how complex industrial products can be optimally sourced when the buyer’s primary goal is to identify and incentivize innovation. In contrast, most previous research on procurement has concentrated on cost-reduction efforts. Methodology: We use a game-theoretic model to design and compare different procurement mechanisms that allow a buying firm to tap into the innovation potential of its supplier base. Results: Three factors largely determine whether a buyer should procure an integrated system or individual components—namely, the novelty of the innovation to be sourced, the size of the supplier base, and the extent and distribution of component integration costs. We demonstrate how buyers can improve the effectiveness of procurement mechanisms via active supplier management. Managerial implications: Our study provides clear guidelines for managers seeking to source complex industrial innovation. The recommendations presented here reveal how the optimal procurement mechanism changes with the characteristics of the desired product and of the buyer’s supplier base.