External Quality Cost Contracting

As companies outsource more of product design and manufacturing activities to other members of the supply chain, improving end-product quality has become an endeavor extending beyond the boundaries of the firms' in-house process capabilities. In this paper, we investigate four contractual arrangements by which external quality costs can be shared between a manufacturer and a supplier to induce quality improvement. Namely, we consider (a) cost sharing based on an ex-ante fixed rate, (b) total cost allocation based on complete root-cause analysis, (c) cost sharing based on selective root-cause analysis and (d) partial cost allocation based on complete root-cause analysis. Using insights from supermodular game theory, for each contractual agreement, we characterize the level of effort the manufacturer and the supplier would exert in equilibrium to improve their process quality when their effort choices are subject to double moral hazard. Relative to the first best performance, we show that the fixed share rate contract leads to underinvestment of effort by both parties, while the total cost allocation based on complete root-cause analysis leads to overinvestment and therefore is supply chain sub-optimal even if the root-cause analysis were perfect and costless. The selective root-cause analysis and the partial cost allocation are identified as coordinating contracts, which can achieve the first best performance from the manufacturer and the supplier. Since these contractual agreements involve an information cost for the supply chain, we discuss conditions under which it would be optimal for the supply chain to seek coordination rather than the second-best performance. This paper is one of the first studies that provides a detailed analysis of a variety of external quality costs sharing contracts, particularly focusing on the use of root-cause analysis information. In that respect, our findings not only enrich the growing literature in this area but are also suggestive to managers regarding the efficiency of these contractual agreements.