Contracting and diagnostic test for new product development under uncertain production reliability

Abstract

This study considers a new product development supply chain consisting of a client and a delegated vendor, and applies a differential game to capture three forms of contracts (original contract, incentive contract, and co-creation contract) with the consideration of the uncertainty of production reliability and variable diagnostic test time. We show that if the client cooperates with an extremely high-reliability (relatively low-reliability) vendor, it is preferable to provide the original contract (incentive contract) and schedule the diagnostic tests early. If the client is working with an extremely low-reliability vendor, nevertheless, offering a contract and providing a later schedule for diagnostic test would be the best decision. Surprisingly, if the client’s partner has relatively high production reliability, offering co-creation contracts is still the best option. The reason is that within this range of reliability, the incentive effect of the incentive contract is diminished and the original contract is not sufficiently reliable. These findings suggest that firms must offer contracts as appropriate and rationalize diagnostic test schedules when cooperating with a new partner to ease delayed delivery caused by uncertain production reliability.