Optimal strategy in managing product quality risk for a risk‐averse manufacturer: Prevention or mitigation?

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AbstractWe explore a single‐period manufacturing system in which component quality is random and a risk‐averse manufacturer decides whether to procure these components from an upstream supplier. We find that product recall insurance could significantly relieve financial pressure for a manufacturer with a high or medium risk aversion. Interestingly, as external failure cost becomes larger, the manufacturer should invest more in inspecting components than enlarging the coverage of insurance. Conversely, when component quality level becomes higher, the manufacturer would purchase an insurance with a larger coverage and set a smaller inspection level. We also find that product recall insurance and incoming inspection are substitutes when the manufacturer has a low risk aversion. While, for a manufacturer with a medium risk aversion, product recall insurance and incoming inspection become complements if the cost of product recall insurance is high.