Supplier Contracts with Profit Sharing, Open-book Costing and Associated Audit Rights

Due to the growing trends in outsourcing and supply chain initiatives, inter-organizational control has become an increasingly important issue in today’s business world. Many businesses set up the so-called "partnering" relationship with their key suppliers. The biggest challenge for this relationship is to find the best mechanisms that align the supplier’s incentive with that of the buyer’s and still maximize each individual firm’s payoff. The purpose of this paper is to present a stylized profit-sharing contract, which is a type of contract commonly adopted to mitigate buyer-supplier incentive problems, and contrast several different types of supplier audit associated with it. Through the analysis of a dynamic Bayesian game, I find the mixed strategy audit in such a contract weakly dominates all other audit methods.