Implications of Innovative Engineering Design on Closed Loop Supply Chain Coordination: Incentives for Input Material Reduction vs. Enhanced Recycling

Motivated by interactions with a major player in the aerospace industry, we consider the relationship between a supplier of specialty material forgings and a buyer that manufactures fabricated airplane components by extensively machining down these forgings as per complex design specifications. Due to high material removal costs, the buyer prefers these forgings to be as similar in geometry and size to the final component as possible, i.e., near-net-shape. The supplier, by default, does not have the capabilities to deliver such near-net-shape forgings as per technological constraints, but can utilize costly effort and/or invest in the required technologies to achieve forging size reduction. By taking into account uncertainty regarding the correspondence between supplier's effort and resulting output (i.e., reduction in forging size), and potential information asymmetry issues due to supplier's private information regarding costly effort, we assess the implications of two innovative approaches our study firm considers for improving supply chain performance: (i) The buyer can partially subsidize the supplier to induce forging size reduction efforts, and/or (ii) the supply chain can facilitate a higher rate recycling of scrap material to reduce input material costs.We find that the supplier's input reduction efforts and enhanced recycling across the supply chain interact in non-intuitive ways, thus inflicting a non-monotone effect on supply chain performance; in other words, an increased recycling rate may misalign incentives, and not reduce decentralization cost. We find that enhanced recycling deteriorates supply chain performance the most especially when the recycling rate is moderate, which suggests that our study firm should participate in a supply chain with either superb or insufficient recycling capabilities. Furthermore, when agency issues arise, we find that the buyer should subsidize supplier's forging size reduction efforts only when the recycling level is above a threshold, which helps improve supply chain performance. In contrast, when the recycling level is below the same threshold, as the buyer bets on the possibility on contracting with an efficient supplier, the buyer withholds any compensation at equilibrium, and thus, enhanced recycling yields a higher decentralization cost.