Mitigating Product Quality Risk under External Financial Pressure: Inspection, Insurance, and Cash/Collateralized Loan

Abstract

We consider a single‐period manufacturing problem wherein a risk‐neutral manufacturer procures product components from an upstream supplier. Component quality is uncertain. Dysfunctional components result in defective products associated with an external failure cost. There is external financing pressure related to financial stress. The manufacturer can use the internal cash‐flow and a collateralized loan to manage product quality risk through incoming inspection, business insurance, and cash hoard. We find that there is no cash hoard if a collateralized loan is used, and the cash hoard's value increases as external financing pressure decreases. Interestingly, more initial internal cash‐flow does not always lead to more investments in inspection and insurance. We also find that business insurance may improve a manufacturer's inspection effort. Finally, we reveal that, as the initial internal cash‐flow increases, inspection and insurance first substitute and then complement each other.