Reducing transactional risk via prototyping in design outsourcing
Date of Issue2014
School of Mechanical and Aerospace Engineering
Design outsourcing is gaining popularity in many industries, such as electronics, aircraft, and automobile etc. Due to its innovative and unpredictable nature, design outsourcing bears more risks in transaction than traditional manufacturing and service outsourcing. In this context, transactional risk is defined as the risks resulted from inherent uncertainty regarding the design outcome faced by both buyers and sellers. Prototypes are commonly used in design outsourcing to elicit customers’ needs and convey designers’ capabilities, such that the information asymmetry and transactional risk would be reduced. However, in capital intensive industries, such as pharmaceutical, and aerospace, etc., prototypes are usually very expensive. Three quantitative models are developed in this research to analyze the trade-off between the value and cost of prototyping in three different, but progressive design outsourcing scenarios: (1) one buyer vs. one designer through single prototyping phase, (2) one buyer vs. one designer through multiple prototyping phases, and (3) one buyer vs. multiple designers through multiple prototyping phases. The single-step prototype model refers to a scenario with bilateral contracting, in which a buyer needs to decide whether to buy the design from a seller. However, the buyer faces uncertainty regarding the value of the design, while the seller faces uncertainty regarding the cost of the design. These uncertainties drive the buyer and the seller to ask for extra premiums to hedge their risks, which could result in no deal even though a mutually beneficial transaction is possible. This model combines utility function and Bayesian updating to quantify the tradeoff between the risk reduction effect and cost of prototyping in design outsourcing. The results show that the prototype indeed reduces the transactional risk and improves customer’s utility. The development of complex systems usually consists of multiple phases. A multiple-step prototyping model is subsequently developed to investigate transactional risk reduction over multiple phases. Instead of making a lump sum investment at front end, the customer can make multiple investment decisions along the development phase with more flexibility. A Bayesian-based real option model is developed to quantify the value of the prototypes. The result suggests that the traditional real option model overestimates the design value, which may lead to excessive investment on unnecessary prototypes. The third model proposed in this research aims to study a multi-lateral scenario with one customer and multiple competing designers, which is more representative of design outsourcing in industries. A systematic quantification of transactional risk based on real option theory is investigated, in conjunction with a study on the customer’s screening decisions along the prototyping process. Numerical study is conducted to verify the validity and performance of the proposed models. The results show that this model is able to locate the optimal prototype value threshold to screen out incompetent design and maximize the customer’s expected payoff. This research extends the research frontier in design outsourcing through introducing three innovative models to quantify the risk reduction through prototyping, to value the prototype in multi-phase development scenarios, and to optimize the buyer’s expected payoff in design contest. Practically, this research is able to assist the management to make informed and cost-effective prototyping decisions in design outsourcing.
DRNTU::Engineering::Industrial engineering::Operations research