Social Responsibility Auditing in Supply Chain Networks

We study a buyer's problem of auditing suppliers within a network to ensure social responsibility compliance. The buyer suffers economic damages if a violation is exposed at a supplier (whether by the media, regulator, or NGO). To avoid damages the buyer may audit them to identify non-compliance. If a supplier fails an audit, the buyer must take one of two costly actions: either rectify the supplier or drop the supplier (along with dependent suppliers). Dropping a supplier reduces competition and therefore increases the buyer's input cost. The network topology evolves as the buyer conducts audits. We build a two-phase model: an auditing phase followed by a production phase. The unique production phase equilibrium arising from the competition in the supply network establishes the buyer's production profit and each supplier's value to the buyer. We then identify the buyer's optimal dynamic auditing policy: the buyer will first audit and drop some suppliers, before either auditing and rectifying suppliers, or proceeding directly to production. Within the audit-and-drop subphase, when auditing only in the upper tier, the buyer always audits the least valuable unaudited supplier, yielding greater balance. We also establish the condition under which the buyer may truncate auditing altogether, carrying unaudited suppliers to production ("hear no evil, see no evil"). When the buyer audits more broadly, any supplier (not necessarily the least valuable) may be chosen. A supplier in a pivotal position may be chosen to help the buyer ascertain the viability of a portion of the network ("litmus test").