Contract Manufacturing and Quality Risk: Theory and Empirical Evidence

Abstract

This paper investigates the relationship between contract manufacturing and quality risk — a term defined as the propensity of a manufacturing plant to operate out of compliance with required procedures. Contract manufacturing plants (hereafter, CM) are increasingly being used in many industrial sectors. While CMs have been anecdotally blamed for many recalls and other outgoing product quality failures, there is a neither a strong coherent theory in operations and supply chain management nor empirical evidence that considers whether and when CMs pose a differential quality risk in contrast to internal plants (IPs). By definition, CMs produce products to another firm’s specifications, whereas IPs make products to their own firm’s specifications. This basic difference between CMs and IPs potentially leads to systemic dissimilarities in their operational contexts. Drawing upon these contextual dissimilarities, we posit that, on average, CMs will operate with higher quality risk than IPs. Subsequently, we develop contingencies related to key factors that moderate the relationship between plant type (CM vs. IP) and quality risk. We test our hypotheses using a plant-level measure of process compliance based on Food and Drug Administration (FDA) inspection data on a sample of 152 plants classified as drug manufacturers by the FDA. In addition to finding moderate evidence of a first-order difference, we do find evidence that production experience and the intensity of external regulation serve as important contingencies regarding quality risk. We find strong evidence that among plants with low production experience, CMs operate with higher quality risk than IPs, but this difference is mitigated as CMs gain production experience. We also find that increased regulatory intensity seems to influence CMs to reduce quality risk more than it does IPs.