Quality uncertainty and quality-compensation contract for supply chain coordination

Many firms often face quality problems, even though quality improvement has long been a competitive imperative for performance enhancement. When suppliers are the sources of quality problems, prior literature has focused on sustaining a buyer's competitiveness given the suppliers' quality uncertainty. Surprisingly, the literature has not paid sufficient attention to quality uncertainty from a coordination perspective. On the other hand, the literature on channel coordination has not considered quality uncertainty in designing a contract of alliance. We bridge the gap between these two streams of literature by explicitly considering quality uncertainty in a coordination framework. In contrast to the coordination literature, we show that channel integration may result in smaller order quantity and less accurate inspection than in a decentralized supply chain if product quality is uncertain. We examine the two most extensively discussed contracts for coordination, buybacks and revenue-sharing, in the presence of quality uncertainty, and find that these two contracts fail to coordinate the supply chain. We then propose a new scheme, the quality-compensation contract, in which the manufacturer compensates the retailer for defective products that are inadvertently sold to consumers, and analytically show that the contract fully coordinates the supply chain. (C) 2013 Elsevier B.V. All rights reserved.