Supplier Quality Management: Investment, Inspection, and Incentives

Abstract

Buyers can manage product quality sourced from suppliers in three ways: they can improve the quality incoming from suppliers directly by investing in suppliers to improve a process/product, they can improve the incoming quality indirectly by incentivizing supplier quality-improvement efforts, and/or they can control the quality outgoing to subsequent processes by inspecting incoming units. In this study, we study a buyer's use of these three instruments—investment, incentives, and inspection—to manage the sourced quality. To do so, we consider a general relationship between the buyer's direct investment effort and supplier's quality-improvement effort, allowing them to be complementary, substitutable, or additive in their quality-improvement effects. For situations in which the buyer and the supplier decide their efforts simultaneously with contractible internal-failure events, we identify three types of strategies: the investment-based strategy (focusing on the buyer's investment effort) for strongly substitutable efforts, the inspection-based strategy (focusing on inspection) for strongly complementary efforts, and the integrative strategy (emphasizing all three instruments) for additive efforts. If buyer-investment commitment is possible, then the inspection-based strategy in which both parties defect in their efforts will be replaced by a collaboration-based strategy in which both parties exert high efforts to improve quality. Contracting upon external failures (in addition to internal failures) does not change this strategy pattern; however, when combined with buyer-effort commitment, such a contract achieves the first-best result.