Contract Types and Supplier Incentives for Quality Improvement

When firms outsource production to suppliers, a key concern is how to control product quality and to motivate the supplier to invest in quality improvement. In practice, several kinds of quality management contracts are commonly used, such as subsidizing the supplier’s quality investment, setting a defect rate target, and a combination of both. This paper analyzes and compares the effectiveness of these approaches in a stylized two-echelon supply chain with deterministic market demand and imperfect batch production process. We show that the appropriateness of a contract form depends on the supplier’s initial quality level as well as the information structure about this level.