Quality Assurance Contracts in a Multi-Level Supply Chain

Firms are often challenged in controlling quality when their supply chains become longer because of outsourcing. Should a firm change its quality control approach to adapt to the longer supply chain? This paper aims to address the question by studying a brand owner’s optimal choice between two commonly used quality control approaches: inspection-based quality control and external failure-based quality control, in two supply chains: a dyadic supply chain and a multi-level supply chain where the brand owner outsources manufacturing to a contract manufacturer. Our study finds that the brand owner’s optimal choice between the two quality control approaches could be opposite in the two supply chains. Specifically, we show that if agency cost exists between the contract manufacturer and the brand owner, it is possible that the brand owner should switch to inspection-based quality control in the multi-level supply chain from external failure-based quality control that is more profitable for the brand owner in the dyadic supply chain. Unlike an external failure-based approach that only takes action after an external failure occurs, inspections add extra value to supply chains directly by preventing defective components and finished products from becoming external failures. In the dyadic supply chain, this extra value created by inspections is internal to the brand owner, who performs both manufacturing and inspections, and therefore, will not affect agency costs. However, in the multi-level supply chain, where the contract manufacturer performs manufacturing and component inspection, part of the extra value created by inspections is not internal to the brand owner anymore and would affect how payments are made and profits are allocated with agency cost implications along the supply chain. In fact, inspections can serve as effective levers for the brand owner to limit the manufacturer’s profit by excluding defective finished products and components, which in turn reduce agency costs. Hence, the efficiency of an inspection-based approach relative to an external failure-based approach can be higher in the multi-level supply chain than in the dyadic one. Our findings suggest that it can be potentially harmful to assume that a quality control approach, which had success in a dyadic supply chain, would continue to achieve the same success in a longer supply chain with outsourced manufacturing. Firms must pay close attention to changes in supply chain structures and re-evaluate the efficiencies of different quality control approaches accordingly. Failing to do so could lead firms with established reputation in quality (e.g., Mattel) to stumble badly on product quality.