Quality Risk in Outsourcing: Noncontractible Product Quality and Private Quality Cost Information

Naval Research Logistics, Vol. 56, pp. 669–685, 2009

17 Pages Posted: 30 Apr 2008 Last revised: 14 Oct 2017

See all articles by Murat Kaya

Murat Kaya

Sabanci University

Özalp Özer

Jindal School of Management - The University of Texas at Dallas

Date Written: April 1, 2008

Abstract

This paper addresses the concept of quality risk in outsourcing. Recent trends in outsourcing extend a contract manufacturer's (CM's) responsibility to several functional areas such as research and development and design in addition to manufacturing. This trend enables an original equipment manufacturer (OEM) to focus on sales and pricing of its product. However, increasing CM responsibilities also suggest that the OEM's product quality is mainly determined by its CM. We identify two factors that cause quality risk in this outsourcing relationship. First, the CM and the OEM may not be able to contract on quality; second, the OEM may not know the cost of quality to the CM. We characterize the effects of these two quality risk factors on the firms' profits and on the resulting product quality. We determine how the OEM's pricing strategy affects quality risk. We show, for example, that the effect of noncontractible quality is higher than the effect of private quality cost information when the OEM sets the sales price after observing the product's quality. We also show that committing to a sales price mitigates the adverse effect of quality risk. To obtain these results, we develop and analyze a three-stage decision model. This model is also used to understand the impact of recent information technologies on profits and product quality. For example, we provide a decision tree that an OEM can use in deciding whether to invest in an enterprise-wide quality management system that enables accounting of quality related activities across the supply chain.

Keywords: quality risk, quality effort, outsourcing, contracting, quality management, supply chain management

JEL Classification: C72, D82, L15, L23, M11

Suggested Citation

Kaya, Murat and Özer, Özalp, Quality Risk in Outsourcing: Noncontractible Product Quality and Private Quality Cost Information (April 1, 2008). Naval Research Logistics, Vol. 56, pp. 669–685, 2009. Available at SSRN: https://ssrn.com/abstract=1121444

Murat Kaya

Sabanci University ( email )

Sabanci Universitesi MDB Fakultesi
Orhanli Tuzla
Istanbul, 34956
Turkey
90-216-483 9622 (Phone)
90-216-483 9550 (Fax)

HOME PAGE: http://myweb.sabanciuniv.edu/mkaya/

Özalp Özer (Contact Author)

Jindal School of Management - The University of Texas at Dallas ( email )

Jindal School of Management
800 W. Campbell Road
Richardson, TX 75080
United States

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