Supplier Quality Management: Investment, Inspection, and Incentives

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.