An analysis of contract form for supply chains with quality improvement

• Published date: 01 November 2018
• Date: 01 November 2018
• DOI: http://doi.org/10.1111/itor.12266
• Author: Xinghao Yan*

Intl. Trans. in Op. Res. 25 (2018) 1879–1906

DOI: 10.1111/itor.12266

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IN OPERATIONAL

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An analysis of contract form for supply chains with quality

improvement

Xinghao Yan*

Ivey Business School, WesternUniversity London, Ontario, Canada

E-mail: xyan@ivey.uwo.ca [Yan*]

Received 26 May2015; received in revised form 26 October 2015; accepted 28 December 2015

Abstract

This study examines different contract forms for the supply chain with quality improvement decision and

retailer price decision. We consider three types of quality improvement: cost consuming, cost identical, and

cost saving,which correspond to the cases in which quality improvement leads to an increment, no change,and

a decrease in production cost, respectively. We compare the performance of two types of quality contracts:

(1) pay-before-performance contract, under which the supplier receives monetary support from the buyer

before exerting quality improvement effort; and (2) pay-after-performancecontract, under which the supplier

receives monetary compensation based on the outcome of effort. We find that the performance of each

contract depends on the types of quality improvement. Further, the pay-after-performance contract leads to

close-to-perfect contract efficiency and dominates the pay-before-performance contract from the supplier’s

perspective in most cases. However, this result does not apply in two extended cases: when there are multiple

competing suppliers, the pay-before-performance contract can dominate the pay-after-performance contract

if quality improvement is cost consuming; and when the buyer can exert sales effort, neither contract can

achieve close-to-perfect efficiency in most cases.

Keywords:contracting; quality improvement; pay-before-performance; pay-after-performance

1. Introduction

Retail price and product quality are both key decisions that influence product demand and usually

are made by different players in decentralized supply chains.In this paper we consider a basic supply

chain model consisting of one supplier (she) and one buyer (he): while the supplier decides quality

improvement effort, the buyer decides retail price. Usually there are two types of costs associated

with quality improvement: the first is a fixedcost that indicates the cost needed for developing a new

technology, designing a more effective production process, or setting up programs to train more

skilled staff, etc.; the second is the production cost. Depending on the correlation between product

quality and production cost, there are three types of quality improvement: (1) cost consuming,

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International Transactionsin Operational Research C

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1880 X. Yan / Intl. Trans. in Op. Res.25 (2018) 1879–1906

which occurs when a higher product quality level requires a higher unit production cost. This

happens when the supplier improves product quality by using more expensive materials or more

labor; (2) cost identical, which occurs when the supplier improves the product by applying a more

expensive production process but still uses the same material/labor for production; (3) cost saving,

which occurs when the unit production cost decreases when product quality is improved. Although

the first two types of quality improvement are more intuitive, the third type is not uncommon. For

example, Garvin (1998) presented a case in whichthere is a negative correlation between the number

of direct labor hours needed to assemble various brands of air conditioners (part of unit production

cost) and their relative quality rankings.

At present, firms pay increasing attention to product quality as quality issues permeate media

reports. For example, in 2002, nine of the top 10 recall actions worldwide were due to the quality

deficiencies of suppliers’ products (Maurer et al., 2004). Many quality-related scandals emerged in

different industry fields, for example, toys (Spencer and Casey, 2007), tires (Welch, 2007), medicine

(Layton, 2010), etc. Both suppliers and buyers careabout product quality since high-quality attracts

more customers and hence benefits both of them via high demand; conversely, low product quality

ruins product reputation and may incur recalling cost, which hurts both players. Therefore, devel-

oping appropriate contract forms to better manage suppliers’ incentives for quality improvement is

critical, especially in the context of joint decision of both product quality and retail price.

Since quality improvement efforts are generally exerted by the supplier, the associated effort cost

is not verifiable to the buyer and hence cannot be included in contracts due to moral hazard and

information asymmetry. Accordingly, there are two options for quality contracts: the first is the

pay-before-performance contract, under which the buyer provides monetary support to encourage

the supplier’s incentive for quality improvement before the supplier does so. On the one hand, this

monetary support can be the buyer’s indirect investment to facilitate the supplier’s improvements

to product quality. For example, the supplier can be assisted by the personnel assigned by the

buyer to improve her operations, or receive education and training programs from the buyer to

help her employees on quality improvement (Liker and Choi, 2004; Maurer et al., 2004). On the

other hand, the supplier can require a certain monetary support from the buyer for her quality

improvement effort. This monetary support for the supplier’s quality efforts can be observed not

only in traditional supply chains (Lewis and Sappington,1990), but also in health care supply chains

in which a quality improvement subsidy is paid by the government to suppliers (Shin and Kim,

2010). Since the monetary support is set before the quality improvement effort is exerted under pay-

before-performance contracts, it does not depend on the effort decisions and can be regarded as a

side payment. Thus, we consider the pay-before-performance contract as a two-part tariff contract.

The second option is the pay-after-performance contract, under which a monetary compensation

paid to the supplier depends on the performance/outcome of the supplier’s quality improvement

efforts. In quality-related literature, there are two types of quality measures, within which the

payments based on quality improvement performance are also different. The first type of quality

measure is conforming rate(or defective rate), which indicates the percentage of productsthat satisfy

a certain product design specification. Accordingly, the payments based on quality improvement

performance can be penalty costs of the returned/recalled defective units or inspection costs of

the defective units. The second type of quality measure is product quality, which indicates the level

of the product function. Accordingly, the payments based on quality improvement performance

include sales rebate (Taylor, 2002; Krishnan et al., 2004), order quantity discount (Kolay et al.,

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2016 The Author.

International Transactionsin Operational Research C

2016 International Federation of OperationalResearch Societies