Mechanism Design for Managing Hidden Rebates and Inflated Quotes of a Procurement Service Provider

Problem definition: When sourcing through a procurement service provider (PSP), the PSP often collects rebates from unethical manufacturers in developing countries (as referral fees) that are “hidden” from the retailers. Recognizing that a PSP has a strong incentive to solicit quotes from unethical manufacturers, we examine a situation in which the retailer insists on soliciting a quote from a manufacturer designated by the retailer and a separate quote from an unethical manufacturer selected by the PSP. However, when the designated manufacturer is ethical, the PSP has an incentive to inflate the quote from this ethical manufacturer in order to help the unethical manufacturer to win. Facing this situation, is there a mechanism for the retailer to control hidden rebates? Academic/practical relevance: The issue of hidden rebates is a “known secret” in global supply chain practice. Also, hidden rebates increase the customs duty for U.S. importers because of the first sales rule for customs valuation of U.S. imports. Therefore, there is a need to understand the implications of hidden rebates and to control this unethical practice. Methodology: To circumvent the issue of hidden rebates and quote inflations, we develop a deterministic, incentive-compatible mechanism that is based on a simple selection rule (for selecting a manufacturer) and a contingent service fee (as a reward for the service provided by the PSP). Results: Our optimal mechanism creates incentives to (1) deter the PSP from inflating the quote submitted from the ethical manufacturer, (2) reduce the incidence of hidden rebates, and (3) reduce the retailer’s procurement cost and the corresponding import tax significantly. More importantly, relative to the “lowest quote wins” selection rule, the optimal mechanism is Pareto-improving for the retailer and the service provider when the hidden rebate is below a certain threshold. Furthermore, we extend our analysis to the case in which (1) the retailer is not sure whether the designated manufacturer is ethical or not, (2) the retailer does not know the exact value of hidden rebate (but it follows a two-point distribution), and (3) the retailer may verify the quote with its designated manufacturer before a formal contract. We also explore the stochastic incentive-compatible mechanism for the cases in which the penalty is unenforceable or enforceable. Managerial implications: When law enforcement is inconsistent in developing countries, retailers should beware of the existence and implications of hidden rebates. We provide a simple mechanism that a retailer can consider as a practical way to deter the PSP from inflating certain quotes and put hidden rebates under control.