Managing Quality Risk in a Decentralized Supply Chain: Contractual Incentives and Product Recall Insurance

We consider a two-echelon decentralized supply chain where the probability of selling nondefective products depends on the supplier’s quality improvement and the buyer’s inspection efforts. Products assembled from defective components cause a recall that leads to external failure costs for the buyer. Both players’ efforts are not contractible and it is a challenge to align inspection and quality-improvement efforts in a decentralized supply chain. We find that a procurement contract can provide preventive incentives that induce high inspection efforts and enhancing incentives that enable the supplier to credibly commit to high-quality components. However, these contractual incentives only align two players’ efforts under certain conditions. Interestingly, our findings suggest that introducing a product recall (PR) insurance requirement into a standard procurement contract provided by the buyer can complement enhancing incentives and lead to quality improvement in components. More importantly, as PR insurance can improve the flexibility of risk-sharing arrangements between the supplier and the buyer, we show that it can also serve as a coordinating role in improving the performance of a decentralized supply chain.