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.