Supplier Capability Signaling Through Investment in Quality Improvement

What is it about?

Identifying a supplier's capability in delivering high-quality consignments is critical for a manufacturer who might incur a non-contractable hidden cost of poor quality if the selected supplier is of low-capability type. A supplier's investment in quality improvement through defect reduction can be a useful signal. However, the manufacturer is misled by the signal if the effect of preventive investment in reducing the cost of quality (COQ) is ignored. We analyze a signaling game between a manufacturer and a supplier, factoring in the decrease in COQ through a reduction in appraisal and failure costs resulting from investment in quality improvement. If the manufacturer is a payoff maximizer, then a high-capability supplier lacks incentive to signal type. However, surplus sharing, induced by the manufacturer's inequity aversion, incentivizes the high-capability supplier to signal type through investment in defect prevention. Separating perfect Bayesian equilibrium (PBE) exists if the capability gap between types of suppliers, or the non-contractable hidden cost to the manufacturer, is not too small. The likelihood of separating PBE increases with an increase in the capability gap and the supplier's equitable share of the surplus. Our analysis helps manufacturers avoid the hidden cost of poor quality by identifying a high-capability type supplier correctly, factoring in the effects of investment in the supplier’s appraisal and failure costs. Finally, our numerical simulation provides operational guidelines to the manufacturer for designing an effective signaling game, while ensuring an equitable distribution of supply chain surplus.

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Why is it important?

Our model provides strategic insights for a manufacturer who is in search of a high-capability supplier as well as for the supplier. In summary, the signaling mechanism works unless the capability gap between high and low-capability types and the hidden cost of the manufacturer are not too small. This understanding induces a high-capability supplier to choose an investment that is not viable for a low-capability supplier, and such an investment helps the manufacturer identify a high-capability supplier. Long-term benefit of selecting a capable supplier: When a supplier is identified as capable, the manufacturer may decide to conduct only an `identity check' of future lots - a process commonly known as `dock-to-stock' - to reduce time and effort. Benefit from equitable surplus distribution: Our analysis exposes the criticality of equitable surplus distribution. If the manufacturer appropriates the entire surplus, a high-capability supplier chooses not to signal type and instead extracts information rent. Benefit from costly signal: If the supplier is relatively new, lacks high-quality credentials, or operates in a market where a randomly selected supplier is unlikely to be a high-capability type, the supplier must invest at the low-capability type's non-viable level to get the contract. Implementable guidelines: Based on our numerical simulation, we suggest that the supplier carefully plan the investment decision, specifying appropriate investment effectiveness and inspection resources, whereas the manufacturer demands a zero-defect consignment target and imposes a high penalty if the supplier fails to meet it. Such decisions are more important for products with higher consignment value.