Penalties, rewards, and inspection: provisions for quality in supply chain contracts

Rewards for better quality, penalties for poorer quality, and the type of inspection policy are among the most common quality-related provisions of supply chain contracts. In this paper, we examine the effect of rewards, penalities, and inspection policies on the behaviour of an expected cost minimizing supplier. We assume that the supplier selects a batch size and target quality level in order to meet a buyer's deterministic demand. We show that the reward and/or penalty that motivates a supplier to deliver the buyer's target quality depends upon the inspection policy. We also show that, when sampling inspection is used, penalties and rewards are substitutes for one another in motivating the supplier and that there exists a unique reward/penalty combination at which the buyer's expected cost of quality is zero.