Financial Incentives to Avoid Major Quality Problems in a Supply Chain

Manufacturers who outsource components incur risks as well as benefits. If the supplied product has a major quality defect, the adverse effect on the manufacturer’s reputation reduces its market share. This paper presents a discrete-time model of a buyer who collaborates with a sole supplier to avoid quality problems by paying a higher per-unit purchase price to the supplier and/or paying the supplier a lump sum contingent on the absence of a major quality defect. Analytical results include an optimal risk-posture policy for which the buyer should use only one of these financial incentives or the other, and computational results provide insights about the relationship of that optimal policy to various parameters.