Despite the many benefits of outsourcing, firms are still concerned about the lack of critical information regarding both the risk levels and actions of their suppliers, who are usually just a few links away. Usually, companies manage supply chain risks by deferring payments to suppliers until after the delivery has been made. Even though the deferred payment approach shunts the risk from the buyer to the supplier, recent supply chain failures suggest that it does not necessarily eliminate the risk completely. Hence, many companies offer incentives and conduct inspections of the actions taken at the source rather than waiting for the end delivery. In this paper, we study the effectiveness of such incentive and inspection mechanisms undertaken by manufacturers to manage the quality of suppliers who are “privately” aware of the risk of failure. By comparing the agency costs associated with each contractual setting, we characterize the value of output- and action-based incentive mechanisms from the perspective of the manufacturer. We find that employing action-based incentives is effective for the manufacturer, specifically when working with a supplier that faces high costs of production and quality improvement. However, if the manufacturer faces high inspection costs or a low degree of information asymmetry, employing an output-based contract that results in differentiated quality improvement efforts becomes more effective. Finally, we analyze the marginal value of the combined contracting strategy and characterize when it strictly dominates over output- and effort-based contracts. The online appendix is available at https://doi.org/10.1287/msom.2017.0652 .
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