Contract Design for Supply Chain Quality Management

Cost reduction has been a major driver of outsourcing. However, recent product recalls suggests that purchasing cost reduction alone is not enough. In this paper, we incorporate the Total Cost of Ownership (TCO) perspective into a two-stage leader-follower game to analyze the decisions made by one buyer and one supplier with a quality cost-sharing contract in a supply chain. Our analysis suggests that the optimal quality chosen by the supplier increases in its own cost efficiency, the buyer’s profit margin and the wholesale price offered by the buyer, the optimal wholesale price set by the buyer decreases in the supplier’s cost efficiency level and its own profit margin and an appropriate cost-sharing percentage exists between the buyer and the supplier. Our research provides managerial insights on how to induce the supplier to offer quality products along the supply chain in today’s global outsourcing environment