Choosing the right contract structure can incentivize suppliers to deliver higher quality products
Supply chains went global long ago, but effectively monitoring product quality in distant factories is a challenge that companies are still working to overcome.
Language barriers and an unfamiliar regulatory landscape can make it difficult to know exactly what’s happening during the production process. If a supplier chooses not to inform a manufacturer that product quality has been compromised, the manufacturer might not figure it out until a defective shipment has already been accepted.
The risk is rooted in information asymmetry. Contract manufacturers and suppliers know exactly which processes and materials were used in the production process, but they have little incentive to share any information that undermines their ultimate goal of getting paid. While this increases the risk of receiving a subpar product, most companies have been willing to accept that risk given the promise of wider profit margins.
But when suppliers cut corners, margins can evaporate quickly. In 2007, Mattel recalled 1.5 million toys because lead paint had been used by one of its suppliers in China—without the knowledge of the California-based toy manufacturer. This led to a $2.3 million fine, $30 million in recall costs, a $50 million class action settlement, and untold lost sales. That’s a pretty high price to pay for Dora the Explorer dolls.
“In most cases, it’s intentional,” says Mehmet Gumus, an Associate Professor of Operations Management at McGill University. “There is a huge incentive for a supplier to inflate their costs, and no incentive to tell their clients about it. It can be an issue any time you work with someone outside of your own organization.”
Cutting corners for immediate gains
In a recent research project, Gumus and Mohammad E. Nikoofal of Ryerson University’s Ted Rogers School of Management analyze how companies can optimize their approach to product quality inspections and production audits to better avoid the hazards of information asymmetry.
Their work was inspired in part by Gumus’ collaboration with a European manufacturer of custom electric cables. He recognized that the company was experiencing product quality issues with some of their suppliers in the Middle East.
“There are different grades of copper and each grade has a different cost,” Gumus says.
“So, a supplier has an incentive to use a lower grade copper. Electric cables are also one of the main ways that fires are started, especially in industrial projects. The plastic used needs to be resistant to fire and high temperatures.”
Western companies have tended to deal with this type of risk by using contracts that set product quality benchmarks that their suppliers must meet. The supplier’s finished product is inspected, and if the benchmarks set out in the contract appear to have been met, the supplier gets paid. If not, they don’t.
This approach is effective in shifting the risk to the supplier. But manufacturers remain vulnerable to quality compromises that inspections fail to identify, which can put them in the situation of having to accept a supplier’s assurances that the agreed-upon processes and materials were used.
“In a B2B setting, you should always consider verbal confirmation that a process has been followed with a grain of salt,” Gumus says.
Auditing manufacturing processes at the production site can be more effective, but requires more resources.
“Before a production order is submitted, a manufacturer sends their people to monitor a supplier’s actions,” says Gumus.
“Are they using the right grade of copper? Are they following certain rules when they put the insulating material around the copper? This approach is more costly, but manufacturers gain two advantages: real information about the manufacturing process and the ability to influence that process. This leads to better supply chain efficiency and potentially lowered overall costs. But the downside is that they take on risk. If you send me the auditors to inspect the entire process, and the product still fails, that's on you.”
Tailoring quality control to the manufacturer-supplier relationship
But which approach is better? That depends on the costs involved in auditing and improving processes, the accuracy of final product inspections, and the level of information asymmetry in the manufacturer-supplier relationship.
An audit-based approach can help ensure that production processes are being adhered to and is the preferred approach (i) when the costs of auditing the process are low, (ii) when a supplier bears the cost of improving processes, and (iii) when the degree of information asymmetry is high—meaning that there is a heightened possibility of compromised product quality.
On the other hand, when the costs of auditing processes are high and the degree of information asymmetry is low—meaning a compromise in quality is less likely, a contract that uses quality benchmarks will be effective.
But neither approach is as accurate as a combination of the two. A manufacturer can specify that a portion of payment will be contingent on a product passing a final quality inspection, and another portion will be contingent on process audits. This approach is especially effective when the accuracy of both inspections and audits is low.
The power of relationship building
In the future, blockchain could help eliminate the need for an audit-based approach to quality control by enabling manufacturers to monitor each individual input that their suppliers use. But, for that to work, the technology would need to be adopted at every step of a supply chain, all the way back to resource extraction.
For now, a decidedly more low-tech solution can yield results—fostering long-term relationships with suppliers. The prospect of repeat business can be a powerful motivator in ensuring that a supplier holds up its end of the bargain.
“If suppliers envision interacting with a client later on, some of the issues related to information asymmetry or incentives disappear,” says Gumus. “Not completely,” he cautions, “but to a level where the supplier’s incentive changes.”
“Their motivation is no longer immediate profit, but future deals secured from the same manufacturer. You need to consider your reputation. Typically, if you develop a long-term relationship, things get better. The problem gets fixed by itself without having to use these mechanisms.”