Coordinating a two-stage supply chain with external failure cost-sharing and risk-averse agents

Production processes are not defect-free in reality, and such imperfect processes generate external failure costs . In this paper, we study a two-stage supply chain under a manufacturer-led Stackelberg setting, a supplier-led Stackelberg setting, and a centralized setting. A risk-averse supplier shares external failure costs with a risk-averse manufacturer, who will be encouraged to conduct quality improvement investments. Analytic results are derived. In order to investigate how the external failure cost-sharing ratio, channel power leadership, and quality improvement investments affects the optimal solution, a comparative analysis is performed. We also propose a new contract that considers external failure cost-sharing between the two supply chain members to coordinate a decentralized system. A numerical example is given to illustrate the proposed theorems and influences of some critical parameters on the equilibrium results under different supply chain structures. Although traditional wisdom suggests that channel power will benefit the supply chain leader, we show an opposite result under the premise that the external failure cost-ratio shared by the dominant player is high enough. Specifically, we also theoretically demonstrate that quality improvement investments can always bring higher profits to parties under any supply chain system and numerically prove that the more risk-averse partners gain less profit in the two-echelon supply chain under the Mean–Variance framework. • A two-stage supply chain with external failure cost-sharing and risk-averse agents is developed. • Impacts of risk aversion and the external failure cost-sharing ratio on quality improvement investment decision is investigated. • Coordination of two-stage supply chain with external failure cost-sharing and risk-averse agents is studied. • A comparison of Revenue Sharing and External Failure Cost-Sharing contract and two-part tariff contract is provided. • Conditions that Revenue Sharing and External Failure Cost-Sharing contract leads to perfect coordination are obtained.