Abstract:

Globalization, technology complexity, high investment for new technology and new market entry make it impossible for firms to do everything by themselves (Webster 1992). Firms have to rely more on purchased materials, supplies, product subassemblies and services from a substantial number of suppliers. The quality produced by suppliers directly impacts final product quality. Furthermore, consumer expectations about quality level tend to increase over time. Thus continuously improving quality is a competitive imperative for many firms. Because the quality of finished items can be affected by many different suppliers, managing quality improvement from variety suppliers can be extremely challenging.

There are a number of ways to improve the quality of purchased parts and components. Firms can use a succession of relatively short term arm's length approach (take it or leave it) that require suppliers to steadily improve quality over time. Firms can work collaboratively with suppliers to improve the quality. Firms can also use performance based incentive approach to provide monetary incentives to make the supplier improve the performance and quality (Holmstrom 1979, Basu, Lal, Srinivasan , Staelin 1985, Bergen, Shantanu, Walker 1992). However, it is difficult to use a succession of take it or leave it approach when the market is dominated by a few strong suppliers (Banker, Khosla and Sinha 1998), it may not be economically wise to collaborate with the suppliers due to the concern of time and energy required (Tirole 1993) and it has negative impact for buy's bottom line to pay supplier more.

In practice, firms often use their purchase power to seek better price from the suppliers, quantity discount is prevailing in every business. However, there is little research on how firms use their purchase power to seek continuous quality improvement, a strategic competitive advantage, from their suppliers with no extra resources involved. Motivated by the situation described above, in this research we propose an alternative approach, a quantity incentive contract, to make the supplier improve quality continuously over the contract term. Unlike the take it or leave it approach, quantity incentive contract provides the supplier the opportunity to explore the revenue potential. When compared with collaboration and monetary incentive approaches, quantity incentive contract doesn't require extra resources from the firms.

We use a dynamic model to formulate and analyze quantity incentive contract. We assume that a firm has the flexibility to reward the supplier with more order quantity but has no intention to pay more for better quality over time. The firm also specifies the minimum quality level in the contract, any quality below the minimum level will be rejected otherwise accepted. The supplier's objective is to maximize current value profit over the contract term if she enters the contract with the firm.

This research offers four main contributions. First, we show that, under comparatively mild constraints, quantity incentive contract is effective to drive the supplier to improve quality over time. Second, we identify the condition under which the intertemporal quality equilibrium is stable. Third, we show how various key environmental factors i.e. market force, quality improvement efficiency interacting to influence supplier's quality improvement process decision over time. Fourth, we provide the insights on how to design quantity incentive contracts in a dynamic setting.