EXPRESS: Catch-All or No-False-Alarm? Managing Socially Responsible Supply Chains with Imperfect Audits

Firms commonly use audits to ensure their suppliers comply with social responsibility standards. Yet audits are imperfect: a type I error occurs when a compliant supplier is mistakenly flagged as non-compliant, and a type II error occurs when a non-compliant supplier is overlooked. We study an assembly network in which a firm sources inputs from two suppliers and designs an audit program under a limited budget. For each audited supplier, the firm determines the audit accuracy and the associated type I and type II error rates. Upon a failed audit, the firm decides whether to rectify the supplier or substitute it with a compliant one. We show that the firm's audit strategy depends on the relative costs of substitution and rectification, as well as the allocated budget. When both mitigation costs are high or one of them is low, the firm always prioritizes addressing a specific type of error, regardless of the budget level. When both mitigation costs are moderate and substitution is cheaper than rectification, the budget level becomes pivotal. With a higher budget, the firm may prioritize reducing type I errors and substituting flagged suppliers to leverage cost advantages of substitution. With a tighter budget, the firm instead prioritizes reducing type II errors and relies on rectification to avoid potential reputational damage from type I errors. Interestingly, even in a symmetric network, the firm may allocate the budget unevenly: assigning more resources to one supplier to take advantage of low-cost substitution, while allocating less to the other and relying on rectification when needed. Surprisingly, as the budget increases, the firm may shift from auditing both suppliers to auditing only one, improving audit accuracy for the audited supplier while accepting a fixed expected loss from the unaudited one. Moreover, a larger budget may increase the probability that a non-compliant final product reaches the market, because the firm may switch from eliminating type II errors to controlling type I errors. The optimal audit program differs sharply from the one that ignores type I errors, which can result in inefficient budget allocation, misguided mitigation efforts, and avoidable reputational and economic losses. Our findings highlight the importance of jointly managing both types of audit errors and strategically adapting the audit scope, intensity, and corrective actions in socially responsible sourcing.