This paper considers a manufacturer who outsources the production of a product to multiple competing suppliers, who differ in their cost structures and in their capabilities for producing high-quality products. The manufacturer must design the sourcing process to ensure that the selected supplier has sufficient quality capability, while encouraging competition among the suppliers. We develop and analyze a mathematical model of performance-based contracting, a sourcing method that is appropriate when the manufacturer has imperfect information regarding the suppliers’ costs and capabilities. We compare the performance of performance-based contracting with that of a two-stage sourcing process, an alternative sourcing method that is more commonly used in practice. The theoretical results and managerial insights derived from this research can enable manufacturing firms to improve the management of their sourcing processes. In particular, we demonstrate that performance-based contracting with a symmetric linear penalty/reward function will always outperform the two-stage sourcing process from the perspective of the buyer and that the optimal penalty/reward rate is less than or equal to the unit warranty cost. In addition, performance-based contracting generally leads to a higher quality level provided by the winning supplier. However, the winning supplier is generally better off under the two-stage sourcing process
