Omega 113 (2022) 102707

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Omega
journal homepage: www.elsevier.com/locate/omega

How to outsource production considering quality management:

Turnkey or buy-sell?R
Manman Zhang a,c, Juliang Zhang a,∗, Yue Sun a, T.C.E. Cheng b
a
Department of Logistics Management, School of Economics and Management, Beijing Jiaotong University, Beijing, 100044, China
b
Department of Logistics and Maritime Studies, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong SAR c China Postal Savings Bank
Co., Ltd. Beijing Branch
c
China Postal Savings Bank Co., Ltd. Beijing Branch

a r t i c l e i n f o a b s t r a c t

Article history: As a common practice in many industries, outsourcing has two main structures, namely turnkey (con-
Received 21 July 2021 tract manufacturers (CMs) purchase components from suppliers directly) and buy-sell (original equip-
Accepted 6 June 2022
ment manufacturers (OEMs) purchase components from suppliers and resell them to CMs). However,
Available online 8 June 2022
outsourcing may result in product quality problems. How to choose an appropriate outsourcing structure
Keywords: considering quality management is an important problem faced by OEMs. In this paper we consider a
Outsourcing system comprising one OEM and one CM, and study their equilibrium policies under the turnkey and
Supply chain buy-sell. Then we compare the OEM’s profits under the two structures and identify conditions under
Game theory which one structure outperforms the other one. For the case where the compensation is an exogenous
Quality management parameter, we show that which structure is optimal depends on the compensation, the external failure
cost, the cost differences between the two suppliers and the CM’s crafts, and the non-defective rates of
the low-type supplier and low-level process craft. When the compensation is higher than the external
failure cost, the OEM should choose turnkey. Otherwise, which structure is better depends on the param-
eters. We then consider the case where the compensation is a decision variable and find that the OEM
should choose turnkey. Finally, considering the case where the players have different market powers, we
find that turnkey is optimal when the CM is more powerful. When the OEM is more powerful, turnkey
is better when the external failure cost is low and the OEM’s market power is not too high; otherwise,
buy-sell is better.
© 2022 Elsevier Ltd. All rights reserved.

1. Introduction
As the main form of Apple’s product manufacturing, outsourc-
ing can reduce cost. However, outsourcing also brings uncontrol-
lable quality management problem to the brand owner. Wistron,
one of Apple’s main manufacturers, was told to shut down its
manufacturing plants for two weeks in March 2018. The reason
was that Wistron changed its suppliers of waterproof components
without Apple’s permission, which caused some iPhone 8 Plus
products to have quality problems. As a result, Wistron’s share
price fell more than five per cent. On 31 August 2018, Apple an-
nounced a remedy for the sold iPhone8 Plus with quality prob-
lems, and confirmed that they could provide free repairs or even
R
Area: Supply Chain Management. This manuscript was processed by Associate
Editor Deng.
∗
Corresponding author at: Beijing Jiaotong University, No. 3 Shangyuancun,
Xizhimenwai, Haidian District, Beijing 10 0 044, China.
E-mail address: zhangjl@bjtu.edu.cn (J. Zhang).
replace the defective phones. Incidentally, from 2019 to 2020, Ap-
ple had about ten times of major product repairs and recalls due to
product quality issues. This had caused great losses to Apple1 . Ev-
idently, how to manage product quality in outsourcing is a critical
problem faced by Apple.
In fact, outsourcing has become a common practice in many
industries and will continue to grow in popularity [1]. The con-
tract manufacturer (CM) generally has a lower cost structure than
the original equipment manufacturer (OEM) due to factors such
as manufacturing expertise, scale economy, and location advantage
from operating in low wage countries [2,3]. Thus the OEM could
take full advantage of outsourcing to gain in per-unit cost, capital
avoidance, flexibility, and speed to market, while focusing on its
core competencies of innovation, design, and marketing [4]. Com-
panies like Apple, Mi, Hewlett-Packard, and Cisco have long been
relying on CMs to assemble their final products. Even Dell has re-
cently shifted away from the build-to-order mode by outsourcing
1
https://support.apple.com/service-programs.

https://doi.org/10.1016/j.omega.2022.102707
0305-0483/© 2022 Elsevier Ltd. All rights reserved.
M. Zhang, J. Zhang, Y. Sun et al.
assembly work to some CMs since facing an increasing pressure to
achieve cost competitiveness [5–7].
With the development of outsourcing, two main outsourcing
structures have appeared, e.g., turnkey (the OEM outsources com-
ponent procurement where it lets the CM purchase directly from
the suppliers) and buy-sell (the OEM takes care of component pro-
curement where it purchases components from the suppliers and
resell them to the CM). Some firms prefer turnkey, e.g., Cisco del-
egates component procurement to its CMs [8] and Dell delegates
procurement of components for its laptop PCs to CMs in Taiwan
[9]. On the other hand, other firms adopt buy-sell, e.g., Hewlett-
Packard and Apple [10].
Although outsourcing could help OEMs reduce their costs and
focus on their core competence, the low visibility of quality per-
formance is an enormous challenge that cannot be ignored in out-
sourcing [11,12]. Because of outsourcing, many OEMs have expe-
rienced quality scandals. For instance, Dell recalled notebook bat-
teries due to their potential safety hazards; Apple recalled some
iPhone 8 Plus due to focus problem and iPhone X due to screen
display failure; Hewlett-Packard recalled notebook batteries due to
potential overheating; and Mi’s sales dropped from 70 to 58 mil-
lion in 2016, which was attributed to quality problems [54]. Thus,
how the OEM can take advantage of the low cost of outsourcing
while preventing the CM from causing quality problems is an im-
portant problem faced by the OEM.
It is well known that product quality depends on the compo-
nents purchased from the supplier and the process craft adopted
by the CM. Low-quality products may result from low-quality com-
ponents or/and a low-level process craft. However, it is very costly
for the OEM to supervise the component procurement and process
craft. So when the OEM outsources its production to the CM, it
needs to sign a contract that specifies the outsourcing price, prod-
uct quality, and compensation when the CM provides low-quality
products. It is worth mentioning that low quality components are
not necessarily defective components. For example, low perfor-
mance chips are low quality components compared with high per-
formance chips. Apple released the iPad9 and iPad Pro5 in 2021.
The iPad9 used a chip with poorer performance(A13) than the iPad
Pro5(Apple M1), so it was sold at a low price. Therefore, low qual-
ity means low price. Under this situation, how to design a contract
with the CM that drives it to purchase proper quality components
and/or adopt a proper process craft to produce qualified products
is a critical problem faced by the OEM.
Different firms may receive different preferential treatments
from components suppliers, and the treatments are often related
to the firms’ sizes and other business standings [13]. Thus OEMs
and CMs may have different market powers (here we refer “mar-
ket power” to a firm’s ability to get the component with low price)
over suppliers, resulting in their paying different prices for the
same components. The lower price a party can get from a supplier,
the higher market power the party has. Therefore, it is interesting
to investigate the impacts of the OEM and CM’s market powers on
the choice of outsourcing structure.
Based on the above analysis, this paper attempts to address the
following questions:
(1) Under a given outsourcing structure, what are the optimal
decisions on the quality and cost? How should the OEM de-
sign the contract to induce the CM to use the proper process
craft and/or purchase the proper quality components to pro-
duce the qualified product?
(2) When the OEM wants to outsource its production to the CM,
which outsourcing structure should the OEM adopt to max-
imize its profit and prevent from quality problem?
(3) If the OEM and CM have different market powers, how do
their market powers affect the OEM’s outsourcing decision?
2
Omega 113 (2022) 102707
In this paper we study the equilibrium policies under two out-
sourcing structures, namely turnkey and buy-sell, and which out-
sourcing structure should be adopted considering quality manage-
ment. Specifically, we consider a two-level supply chain consisting
of one OEM and one CM, which purchases components from out-
side suppliers. The CM processes the components into final prod-
ucts. There are two types of suppliers, namely the high-type sup-
plier, which supplies non-defective components, and the low-type
supplier, which supplies components that may be defective. The
CM has two kinds of process crafts, namely the high-level and low-
level crafts. Using the high-level process craft, the CM produces
non-defective products but the cost is high, while using the low-
level process craft, the CM may produce defective products but the
cost is low. The supply chain uses the commonly used external
failure-based approach to manage the quality of the components
and the final product (It is noted that external failure-based qual-
ity management allows the supplier’s components to bypass costly
and time-consuming inspections and be directly used in final prod-
uct manufacturing).
Compared with the existing literature, this paper makes the fol-
lowing contributions:
(1) Note that the outsourcing structure has large impact on the
product quality, we first study the OEM’s choice problem
on outsourcing structure considering quality management as
well as the OEM’s profit.
(2) We characterize the equilibrium policies on the component
quality and process craft, the optimal contract designs and
the OEM’ optimal profits under turnkey and buy-sell struc-
tures, respectively.
(3) By comparing the OEM’s profits under the two structures,
we identify the conditions under which one structure out-
performs the other one under the situations that the com-
pensation is stipulated as the actual cost incurred and as a
decision variable. We further investigate the impacts of the
OEM and the CM’s market powers on the OEM’s choice of
outsourcing structure.
The rest of the paper is organized as follows: In Section 2 we
review some related literature to identify the research gap. In Sec-
tions 3, we state the problem settings and notation used in this
paper. In Section 4 we derive the equilibrium strategies under
turnkey and buy-sell, respectively, and compare the performance
of turnkey and buy-sell when the compensation is exogenous. In
Section 5 we consider the case that the compensation is an en-
dogenous decision variable. In Section 6 we examine the effects of
firms’ market powers on the OEM’s choice of outsourcing structure.
Finally, in Section 7, we conclude the paper and suggest topics for
future research. We give the proofs of all results in the Appendix.
2. Literature review
In this paper, we study the optimal choice of outsourcing struc-
tures considering quality management. There are three streams of
literature, namely, supply chain quality management, product out-
sourcing structure and quality management in product outsourc-
ing.
The first stream of research is on supply chain quality manage-
ment. These studies consider two topics: supplier’s influence on
product quality, and the coordination between suppliers and man-
ufacturers to improve product quality. The studies on the first topic
focus on the impacts of the supplier’s investment or the supplier’s
type on the quality of the final product, e.g., Lai and Cheng [14],
Kannan [15], Hwang et al. [16], Chen and Deng [17], Zhou and
Johnson [18], and Plambeck and Taylor [19].
The second topic studies the coordination and incentive mech-
anism to improve product quality under a given outsourcing struc-
M. Zhang, J. Zhang, Y. Sun et al.
ture. Baiman et al. [20] studied the problem how to coordinate the
supplier’s investment in the component quality, and the producer’s
inspection level and process craft to enhance the product quality.
Singer et. al [21] designed a transfer contract for a supply chain
to increase the members’ income and improve the product quality.
Balachandran and Radhakrishnan [22], and Chao et al. [11] used
cost sharing contracts to incentivize the supplier and producer to
improve product quality. Zhu et al. [23] studied the role of the
buyer and supplier in incentivizing them to improve product qual-
ity. Dai et al. [24] studied the supplier and manufacturer’s equi-
librium policies considering product quality and warranty under
different supply chain environments. Gao et al. [25] proposed a
partial cost allocation contract to induce the supplier to choose
a quality level that maximizes the whole supply chain profit. Lee
and Li [26] studied the supplier quality management problem us-
ing three different instruments (investment, inspection, and incen-
tives). Davis and Hyndman [27] showed that the manufacturer’s
relational and monetary incentives offered to the supplier can im-
prove quality management of a supply chain. Nikoofal and Gümüş
[28] analyzed the advantages and disadvantages of quality-at-the-
end contract and quality-at-the-source contract to incentivize the
supplier to improve quality. Xiao et al. [29] compare the manu-
facturer’s quality investment under the promised acquisition and
the contingent acquisition. Li and Qi [30] investigated the im-
pact of risk aversion on pricing and quality decisions. Wang et al.
[31] studied the joint decision problem on product price, quality,
and service duration in monopolistic and competitive market set-
tings. Bray et al. [32] showed that a geographically concentrated
production network between a firm and its suppliers may have ad-
vantages to improve product quality. Based on the above works, we
can model the impact of the supplier’s type on the product quality
and to design incentive contracts under a given outsourcing struc-
ture. But they only consider the member’s investment and don’t
consider the impacts of the CM’s process craft on the product qual-
ity.
Some works study the impacts of inspection methods on the
product quality. Mayer et al. [33] compared the performance of
supply inspections and plant inspections. Hsieh and Liu [34] in-
vestigated the supplier’s quality investment and the manufacturer’s
inspection strategies with different degrees of information revela-
tion. Dong et al. [35] studied the OEM’s optimal choice of the op-
timal quality management approach (inspection-based or external
failure-based) under two supply chains. In this paper, we assume
that the OEM uses the external failure-based method to manage
the product quality and the defective products can be found by
consumers under each given structure.
The second stream of research related to this study is on pro-
duction outsourcing, which has received extensive attentions. This
stream of research focus on two topics: whether to use outsourc-
ing and which outsourcing structure is optimal.
Cachon and Harker [36] concluded that scale economy provides
a strong motivation for outsourcing. Liu and Nagurney [37] found
that firms’ risk aversion will reduce their outsourcing activities
under competition and foreign exchange uncertainty. Ülkü and
Schmidt [38] argued that outsourcing structure depends not only
on supply chain configurations but also on firms, markets and
product characteristics. Elitzur et al. [39] found that outsourcing
may be better than internal procurement when the marginal cost
of vendor is lower than the marginal cost of the company. Wang
et al. [40] showed that the OEM should outsource its entire pro-
duction to the CM when the CM sets the wholesale price suffi-
ciently low to allow both parties to co-exist in the market in the
case where an OEM outsources its production to a CM that also
produces a competing product. Hou et al. [41] investigated how to
coordinate project outsourcing through bilateral negotiation. Wang
et al. [42] studied whether the buyer should outsource the pur-
3
Omega 113 (2022) 102707
chase to an agent in a supply chain composed of a buyer, a pur-
chasing agent, and a supplier. Sim and Kim [43] showed that the
manufacturer might prefer outsourcing, even if the supplier is rel-
atively less efficient than the manufacturer in terms of quality in-
vestment when there are complementary components.
The studies on the second topic focus on comparing different
outsourcing modes and exploring how to outsource to maximize
its profit(or minimize its cost). Chen et al. [10] identified the con-
ditions under which turnkey or buy-sell is optimal in a three-tier
supply chain where the CM is a competitor of the OEM in the
end-market. Kaya [44] studied the choice of outsourcing and in-
ternal production under the effort-dependent market. Wang et al.
[45] compared the performance of two outsourcing structures un-
der the push and pull contracts. Feng and Lu [46] studied outsourc-
ing contract negotiations between the OEM and CM, and found
that profits could increase when the manufacturers’ bargaining
power decreased. Lin [47] found that the OEM should adopt in-
house production when outsourcing products to a CM with supply
uncertainty in a co-opetitive supply chain. Hu et al. [48] studied
the innovator’s outsourcing decisions under the risk of spillover,
and distinguished technological innovation only through outsourc-
ing and non-technological innovation through market spillover.
These studies provide us methods to establish different outsourc-
ing structures. However, they consider only the OEM’s cost/profit
without product quality. Different from them, we compare the per-
formance of turnkey and buy-and-sell outsourcing structures con-
sidering the product quality as well as the OEM’s profit.
The third stream of research is on quality risk management for
product outsourcing. These works study the sources of quality risk
from outsourcing. Bahli and Rivard [49] showed that transactions,
clients and suppliers are three major sources of quality risk for
IT outsourcing. Kaya and Özer [50] identified the quality risk fac-
tors and quantified their impacts on the profit and product qual-
ity. Dong et al. [35] concluded that outsourcing may lengthen the
supply chain and make quality management more difficult. Caro
et al. [51] found that unauthorized subcontracting will bring many
quality risks. These works didn’t study the impacts of outsourcing
structure on the product quality. Different from the above works,
we analyze the optimal decisions on the component quality and
process craft under different outsourcing structures. Based on this,
we further study the optimal choice of outsourcing structure.
3. Problem settings and notation
In this section we state the problem settings and notation. Con-
sider a supply chain consisting of one OEM and one CM. The OEM
wants to choose an outsourcing structure to outsource its produc-
tion to the CM considering quality management. When the OEM
outsources its production to the CM, they will sign a contract,
which specifies the outsourcing price, the quality, and the com-
pensation when the product quality is found to be lower than the
quality standard.
In this paper, we consider the choice of two outsourcing struc-
ture: turkey or buy-sell. The two structures can be depicted as in
Fig. 1).
Now we define the notation used in this paper. Without loss of
generality, we assume that one unit of the product only needs one
unit of the component and the whole demand is normalized to
one. Suppose that there are two types of suppliers, namely high-
type and low-type, from which the CM and OEM can purchase. The
unit cost of the component supplied by the high-type supplier is
ch , and the component is of high quality and non-defective. The
unit cost of the component supplied by the low-type supplier is
cl (cl < ch ) but the component may be defective. Let the probability
of producing a qualified product be p (0 ≤ p < 1 ) using the com-
ponent from the low-type supplier. Also, the CM has two process
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Table 1
The notation in this paper

ch the unit cost of the component supplied by the high-type supplier

cl the unit cost of the component supplied by the low-type supplier
MH the high-level process craft costs
ML the low-level process craft costs
p the probability of producing a qualified product using the low-quality component
q the probability of producing a qualified product using the low-level process craft
r the OEM’s profit by selling the final product in the market
w the wholesale price
l the external failure cost of each defective product unit
f the compensation from CM to OEM
π (· ) the expected profit
ξ the resell ratio in Buy-sell
ci0 the resell price in Buy-sell
α the decision of purchasing from the high-type supplier by OEM in Buy-sell
β the decision of adopting the high-level process craft by CM in Buy-sell
λ the ratio of CM’s market power to OEM’s market power

case. In this case, the contract is equivalent to the wholesale price

contract.

4.1. Turnkey structure

In this subsection we consider the case where the OEM out-

Fig. 1. Two outsourcing structures
crafts, namely high-level and low-level. The high-level process craft
costs MH and the low-level one costs ML (ML < MH ). If the high-
level process craft is used, the defective probability incurred by the
process craft is 0. If the low-level process craft is used, an addi-
tional defective probability 1 − q will result from the process craft.
Under this situation, there are four different operations strategies:
(H, H ) (purchasing from the high-type supplier, adopting the high-
level process craft), (H, L ) (purchasing from the high-type supplier,
adopting the low-level process craft), (L, H ) (purchasing from the
low-type supplier, adopting the high-level process craft), and(L, L )
(purchasing from the low-type supplier, adopting the low-level
process craft). The corresponding defective probabilities for the fi-
nal product are 0, 1 − q, 1 − p, and 1 − pq, respectively.
The final product will be sold directly in the market, bringing
a profit r to the OEM. The OEM signs a contract with the CM and
pays the wholesale price w to the CM once the CM sells a unit
product to the market (regardless of the quality). We assume that
any defective product will be found in the market and each de-
fective unit will result in an external failure cost l to the OEM. To
ensure that the defective product is unprofitable for the OEM, we
assume that l > r to rule out the trivial case. The CM will give the
OEM a compensation f (the compensation may include the exter-
nal failure cost, the repair cost, the logistics cost, and so on) once
a sold product is found to be defective and the defectiveness is in-
curred by the CM. Table 1 lists the notation used in this paper.
4. Outsourcing with exogenous compensation
In this section we study the optimal decisions under the two
outsourcing structures of turnkey and buy-sell in the situation
where the contract stipulates the compensation as the actual cost
incurred, so the compensation is an exogenous parameter in this
sources the production to the CM under the turnkey structure. Un-
der this structure, the OEM outsources the component procure-
ment by letting the CM purchase directly from the supplier. Then
the CM purchases the components and processes them into the fi-
nal product, and the OEM buys the product and pays the wholesale
price to the CM. Once a sold product is found to be defective, the
CM has to pay the OEM the compensation because the CM is in
charge of component purchase and process.
Note that the CM’s profit is equal to the wholesale price minus
the purchase cost, production cost, and compensation for the de-
fective product, the CM’s profits under the four operations strate-
gies are as follows:
πCM T (H, H ) = w − ch − MH (4.1)
πCM T (H, L ) = w − ch − ML − (1 − q ) f (4.2)
πCM T (L, H ) = w − cl − MH − (1 − p) f (4.3)
πCM T (L, L ) = w − cl − ML − (1 − pq ) f (4.4)
Now we analyze the CM’s dominant operations strategies. Let
c = ch − cl and M = MH − ML . Lemma 1 gives the CM’s domi-
nant operations strategies for a given wholesale price w.
Lemma 1. Given the wholesale price w, the CM’s dominant opera-
tions strategies under the turnkey structure are as follows:
(1) When c < M, the CM’s dominant operations strategies
are shown in Table 2.
(2) When c ≥ M, the CM’s dominant operations strategies
are shown in Table 3.
To visualize the dominant operations strategies, we depict them
in Fig. 2, where Fig. 2-(a) corresponds to Lemma 1-(1) and Fig. 2-
(b) corresponds to Lemma 1-(2).
From Lemma 1, we have the following findings: First, for a
given wholesale price, when f < min{c, M}, the CM will defi-
nitely purchase from the low-type supplier and adopt the low-level
process craft. The reason is that the gain from purchasing from
the low-type supplier and adopting low-level process craft can not
only cover the compensation, but also bring a profit to the CM.
This is consistent with our intuition.

4
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Table 2
CM’s dominant operations strategies whenc < M

Situation Dominant Strategy

f < c (L, L )
c
f ∈ [c, M ) q < (1−p )f (L, L )
c
q ≥ (1−p )f (H, L )
f ∈ [M, c + M ) q < 1 − pM f
(L, H )
q ∈ [1 − pM f
c
, (1−p )f ) (L, L )
c
q ≥ (1−p )f (H, L )
f ≥ c + M p ≥ 1 − f c &q < 1 − pM f
(L, H )
p < min{1 − f c , 1q (1 − c+fM )}&q < 1 − fM (H, H )
c+M
p ≥ max{ q (1 −
1
f
), 1 − q fc }&q ≥ 1 − pMf (L, L )
p<1−  qf
c
&q ≥ 1 − fM (H, L )

Table 3
CM’s dominant operations strategies whenc ≥ M

Situation Dominant Strategy

f < M (L, L )
f ∈ [M, c ) q < 1 − pM f
(L, H )
q ≥ 1 − pM f
(L, L )
M
f ∈ [c, c + M ) q < 1 − pf (L, H )
q ∈ [1 − pM f
c
, (1−p )f ) (L, L )
c
q ≥ (1−p )f (H, L )
f ≥ c + M p ≥ 1 − f c &q < 1 − pM f
(L, H )
p < min{1 − f c , 1q (1 − c+fM )}&q < 1 − fM (H, H )
p ≥ max{ 1q (1 − c+fM ), 1 −  c
qf
}&q ≥ 1 − pMf (L, L )
p<1−  qf
c
&q ≥ 1 − fM (H, L )

When the compensation is not too low, the CM’s dominant op-
erations strategies is complex. Let us take the case where c <
M as an example. Whenc < f < M, Fig. 2-(a)-(ii) reveals that
a low defective rate of the low-level process craft and a large de-
fective rate of the low-type supplier may incentivize the CM to
purchase from the high-type supplier. With a further increase in
the compensation, from Fig. 2-(a)-(iii) to Fig. 2-(a)-(iv), we find
that the tendency is more evident. For the case thatc ≥ M, we
have similar results.
Now we consider the OEM’s optimal contract design problem.
The optimal contract maximizes the OEM’s profit and satisfies the
CM’s participation constraint. We can formulate the problem as the
following optimization problem
max πOEM T (w )
w≥0
s.t. πCM T (w ) ≥ 0
where πCM T (w ) ≥ 0 is the CM’s participation constraint(Here we
assume that the CM’s reservation profit is 0 to simplify the analy-
sis. From the arguments in Bolton and Dewatripont [52], the analy-
sis and results hold for any non-negative reservation profit). In this
optimization problem, the OEM could adjust the profit distribution
in the whole supply chain by setting the wholesale price. (While
we assume that the compensation is a parameter in this section,
we further discuss the case where the compensation is a decision
variable in Section 5). The OEM’s profits under the four operations
strategies are as follows:
πOEM T (H, H ) = r − w
πOEM T (H, L ) = r − w − (1 − q )(l − f )
πOEM T (L, H ) = r − w − (1 − p)(l − f )
πOEM T (L, L ) = r − w − (1 − pq )(l − f )
Proposition 1 gives the solution of problem (4.5).
Proposition 1. The optimal wholesale price, and the CM’s and the
OEM’s profits under the turnkey structure are as follows:
(1) When c < M, the optimal wholesale price, and the CM’s
and the OEM’s profits are shown in Table 4.
(2) When c ≥ M, the optimal wholesale price, and the CM’s
and the OEM’s profits are shown in Table 5.
From Proposition 1, we find that the CM can only obtain the
reservation profit (here it is zero) and the OEM can set the proper
wholesale price to obtain all of the surplus of the chain. The reason
is that the OEM is the leader and the game has complete informa-
tion, so the OEM can predict the CM’s decision behavior when it
decides the wholesale price.
From Lemma 1 and Proposition 1, we find that the CM’s de-
(4.5) cisions on the purchasing components and process craft adoption
depend on the relationship among the compensation, the differ-
ence between the costs from the high-type and the low-type sup-
pliersc, and the difference between the costs of the two process
craftsM. When the compensation is very low, the CM will buy
from the low-type supplier and adopt the low process craft. When
the compensation is medium, the CM will buy from the low-type
supplier or adopt the low process craft. When the compensation is
very high, the CM will buy from the high-type supplier and adopt
the high process craft to ensure no defective product to be pro-
duced.
4.2. Buy-sell structure
(4.6)
In this subsection we study the equilibrium policy and the
OEM’s and CM’s profits under the buy-sell structure. OEMs
(4.7) (e.g., Hewlett-Packard, Apple, and Mi) adopt buy-sell to reduce the
opacity of outsourcing and have control of component procure-
ment. Different from turnkey under which the CM buys the com-
(4.8) ponents and undertakes all the quality responsibility, the OEM pur-
chases the components and take some quality responsibility under
(4.9) buy-sell.
Under buy-sell, the sequence of events is as follows: The OEM
first offers a wholesale price contract to the CM. Then the OEM

5
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Fig. 2. The CM’s dominant operations strategies under the turnkey structure

Table 4
The optimal wholesale price, the CM’s and the OEM’s profits whenc < M

Situation wT πCM T πOEM T

f < c cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
c
f ∈ [c, M ) q < (1−p )f cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
c
q ≥ (1−p )f ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l
f ∈ [M, c + M ) q < 1 − pM f
cl + MH + ( 1 − p ) f 0 r − cl − MH − ( 1 − p )l
q ∈ [1 − pM f
c
, (1−p )f ) cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
c
q ≥ (1−p) f ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l
f ≥ c + M p ≥ 1 − f c &q < 1 − pM f
cl + MH + ( 1 − p ) f 0 r − cl − MH − ( 1 − p )l
p < min{1 − f c , 1q (1 − c+fM )}&q < 1 − fM ch + MH 0 r − ch − MH
c+M
p ≥ max{ q (1 −
1
f
), 1 − q fc }&q ≥ 1 − pMf cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
p<1−  qf
c
& q ≥ 1 − M
f
ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l

purchases the component. The OEM can choose to purchase either
from the high-type supplier at cost ch or from the low-type sup-
plier at cost cl , and resell it at a price ci0 =ξ ci (i = h, l ), where ξ ≥ 1.
Since we assume that the quality management along the whole
supply chain is based on external failure, the CM will accept it and
pay ci0 to the OEM directly. Finally, the CM decides to process the
component using either the high-level process craft at cost MH or
the low-level one at cost ML . Here we assume that reselling price
is an external parameter rather than a decision variable. We adopt
this assumption because of the following reasons: (i) The compo-
nent’s price is generally set by the market and cannot be set by
the OEM arbitrarily. (ii) As the OEM’s main profit is from selling
the final product in the market rather than reselling the compo-
nent to CM, the OEM does not obtain profit by adjusting the re-
selling price. So the reselling price can be set through bargaining
between the OEM and CM. (iii) If the reselling price changes, then
the wholesale price should also be changed correspondingly to en-
sure the CM’s profit. So only the difference between the whole sale
price and reselling price needs to be considered.
The final product will be sold in the market at the selling price
r. The defective product will be found eventually and incur an ex-
ternal failure cost l to the OEM. If the component is from the high-
type supplier, the CM will make a compensation payment f to the
OEM. However, if the component is from the low-type supplier, the
CM is exempted from liability if the component is defective.
We first study the OEM’s purchasing decision and the CM’s
processing decision under a given wholesale price contract. Let
α ∈ [0, 1] be a decision variable that denotes the OEM’s decision on
“purchasing from the high-type supplier” and β ∈ [0, 1] be a deci-
sion variable that denotes the CM’s decision on “adopting the high-
level process craft”. Then α = 1 (β = 1) means that the OEM (CM)
will purchase from the high-type supplier (will adopt the high-
level process craft) while α = 0 (β = 0) means that the OEM (CM)
will purchase from the low-type supplier (will adopt the low-level

6
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Table 5
The optimal wholesale price, the CM’s and the OEM’s profits whenc ≥ M

Situation wT πCM T πOEM T

f < M cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
f ∈ [M, c ) q < 1 − pM f
cl + MH + ( 1 − p ) f 0 r − cl − MH − ( 1 − p )l
q ≥ 1 − pM f
cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
M
f ∈ [c, c + M ) q < 1 − pf cl + MH + ( 1 − p ) f 0 r − cl − MH − ( 1 − p )l
q ∈ [1 − pM f
c
, (1−p )f ) cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
c
q ≥ (1−p )f ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l
f ≥ c + M p ≥ 1 − f c &q < 1 − pM f
cl + MH + ( 1 − p ) f 0 r − cl − MH − ( 1 − p )l
p < min{1 − f c , 1q (1 − c+fM )}&q < 1 − fM ch + MH 0 r − ch − MH
c+M
p ≥ max{ q (1 −
1
f
), 1 − q fc }&q ≥ 1 − pMf cl + ML + (1 − pq ) f 0 r − cl − ML − (1 − pq )l
p<1−  qf
c
&q ≥ 1 − fM ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l

Table 6
The OEM’s and the CM’s expected profit pairs for different combinations of the two players’ decisions

Adopting the high-level process craft β = 1 Adopting the low-level process craft β = 0

Purchasing from the high-type supplier α = 1 (ξ − 1 )ch − w + r,w − ξ ch − MH (ξ − 1 )ch − w + r − (1 − q )(l − f ),w − ξ ch − ML − (1 − q ) f
Purchasing from the low-type supplier α = 0 (ξ − 1 )cl − w + r − (1 − p)l,w − ξ cl − MH (ξ − 1 )cl − w + r − (1 − pq )l + p(1 − q ) f ,w − ξ cl − ML − p(1 − q ) f

process craft). Table 6 summarizes the OEM’s and CM’s expected
profits for different combinations of the two players’ decisions.
From the problem setting and Table 6, we find that, as long as
the CM adopts the high-level process craft, it is exempted from li-
ability; and if the CM adopts the low-level process craft, it may
compensate the OEM with the specified probability. Obviously, the
specified probability depends on whether or not the OEM pur-
chases from the high-type supplier. If the OEM purchases from the
high-type supplier, the defective product must result from the pro-
cess craft adopted by the CM. So the CM should compensate the
OEM with the process craft disqualification probability 1 − q di-
rectly. If the OEM purchases from the low-type supplier, the de-
fective product may be caused by the component or the process
craft or both. According to problem setting, the CM will compen-
sate the OEM only when the component has no quality problem.
Then the corresponding probability is p(1 − q ).
Now we analyze the two players’ equilibrium strategies.
Lemma 2 gives the OEM’s and CM’s equilibrium policies for a given
wholesale price under the buy-sell structure.
Lemma 2. Given a wholesale price w, the OEM and CM’s equilibrium
policy (α ∗ , β ∗ )is as follows:
(1) When f < M/(1 − q ), the pure strategy (α , β ) = (1, 0 )
is the unique equilibrium. The equilibrium profits are
πOEM B (w ) = (ξ − 1 )ch − w + r − (1 − q )(l − f ) and
πCM B (w ) = −ξ ch + w − ML − (1 − q ) f .
(2) When f > M/(1 − q ), the pure strategy (α , β ) = (1, 1 ) is the
unique equilibrium. The equilibrium profits are πOEM B (w ) =
(ξ − 1 )ch − w + r and πCM B (w ) = −ξ ch + w − MH .
(3) When f = M/(1 − q ), any strategy (α , β ) = (1, β ) (where
β ∈ [0, 1]) is an equilibrium. The profits are πOEM B (w ) = (ξ −
1 )ch − w + r − (1 − β )(1 − q )(l − f ) and πCM B (w ) = −ξ ch +
w − ML − ( 1 − q ) f .
From Lemma 2, we have that whether the CM adopts high or
low-process craft depends on the difference between the compen-
sation and the gain from adopting low-level process. However, note
that the OEM’s profit increases (decreases) with β when the com-
pensation is smaller than or equal to (larger than) the external fail-
ure cost, but the CM’s profit is independent of β . So we can focus
on the largest (smallest) β as the “payoff dominant equilibrium” as
stated in the following corollary.
profits are πOEM B (w ) = (ξ − 1 )ch − w + r and πCM B (w ) = −ξ ch +
w − MH .
(2) If f > l, the game has the unique pure equilibrium (1, 0 ),
and the corresponding equilibrium profits are πOEM B (w ) = (ξ −
1 )ch − w + r − (1 − q )(l − f ) and πCM B (w ) = −ξ ch + w − ML − (1 −
q) f .
Different from the dominant operations strategies under the
turnkey structure, Lemma 2 and Corollary 1 imply that the OEM
will definitely purchase from the high-type supplier under the
buy-sell structure. But for the CM, its dominant operations strat-
egy depends on the compensation. The CM will adopt the low-
level process craft if the compensation is low; otherwise, the high-
level process craft. Thus, compared with turnkey, buy-sell does en-
sure the component’s quality. That is why many OEMs (e.g., Apple,
Hewlett-Packard) use buy-sell to purchase key components, such
as CPU, memory, ODD, HDD etc.
Now we discuss the optimal contract design, i.e., the decision
on the wholesale price, under buy-sell. By similar arguments as
in Section 4.1, we derive the optimal contract under buy-sell by
solving the following optimization problem
max πOEM B (w )
w≥0 (4.10)
s.t. πCM B (w ) ≥ 0
where πCM B (w ) ≥ 0 is the CM’s participation constraint. The fol-
lowing proposition characterizes the solution of (4.10).
Proposition 2. The optimal wholesale price and the players’ profits
under buy-sell are shown in Table 7.
From Proposition 2, under buy-sell, the OEM’s dominant op-
erations strategy is always purchasing from the high-type sup-
plier, and the contract is simpler than that under turnkey. When
the compensation is low, the OEM offers a contract that contains
the component’s resell price, the CM’s process cost, and the CM’s
compensation since the CM’s equilibrium operations strategy is to
adopt the low-level process craft. When the compensation is high,
the OEM should offer a contract that includes the component’s re-
sell price and the CM’s process cost for adopting the high-level
process craft.
4.3. OEM’s optimal outsourcing decision

Corollary 1. When f = M/(1 − q ), (1) If f ≤ l, the game has the In this subsection we identify the conditions that determine the
unique pure equilibrium (1, 1 ), and the corresponding equilibrium OEM’s optimal choice of outsourcing structure by comparing its

7
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Table 7
The optimal wholesale price and profits

Situation wB πCM B πOEM B

f < M ξ ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l
f ≥ M q < 1 − fM ξ ch + MH 0 r − ch − MH
q ≥ 1 − fM ξ ch + ML + ( 1 − q ) f 0 r − ch − ML − ( 1 − q )l

Table 8
OEM’s optimal choice of outsourcing structure whenc < M

Situation Optimal Strategy

f < c p ≥ 1 − qlc T urnkey

p < 1 − qlc Buy − sel l
f ∈ [c, M ) p ≥ 1 − qlc T urnkey
p ∈ [1 −  qf
c
, 1 − qlc ) Buy − sel l
p<1−  qf
c
Buy − sel l /T urnkey
l M
f ∈ [M, l− c ) q < 1 − pM f
T urnkey
p ≥ 1q (1 − c+l M )&q ∈ [1 − pM f
, 1 − fM ) T urnkey
p < q (1 − c+l M )&q ∈ [1 − pM
1
f
, 1 − fM ) Buy − sel l
p ≥ 1 − qlc &q ≥ 1 − fM T urnkey
p ∈ [1 −  qf
c
, 1 − qlc ) Buy − sel l
p<1−  qf
c
Buy − sel l /T urnkey
l M
f ∈ [ l− c , c + M ) p ≥ 1 − l c &q < 1 − pM f
T urnkey
p < 1 − l c &q < 1 − qM f
Buy − sel l
c+M
p ≥ q (1 −
1
l
)&q ∈ [1 − pMf , 1 − fM ) T urnkey
p < 1q (1 − c+l M )&q ∈ [1 − pM f
, 1 − fM ) Buy − sel l
p ≥ 1 − qlc &q ≥ 1 − fM T urnkey
p ∈ [1 −  qf
c
, 1 − qlc )&q ≥ 1 − fM Buy − sel l
p<1−  qf
c
& q ≥ 1 − fM Buy − sel l /T urnkey
f ∈ [c + M, l ) p ≥ 1 − l c &q < 1 − pM f
T urnkey
p ∈ [1 − f c , 1 − l c )&q < 1 − qM f
Buy − sel l
p ≥ 1q (1 − c+l M )&q ∈ [1 − pM f
, 1 − fM ) T urnkey
p ∈ [ 1q (1 − c+fM ), 1q (1 − c+l M ))&q ∈ [1 − pM
f
, 1 − fM ) Buy − sel l
p < min{1 − f c , 1q (1 − c+fM )}&q < 1 − fM Buy − sel l /T urnkey
p ≥ 1 − qlc &q ≥ 1 − fM T urnkey
p ∈ [1 −  qf
c
, 1 − qlc )&q ≥ 1 − fM Buy − sel l
p<1−  qf
c
&q ≥ 1 − fM Buy − sel l /T urnkey
f ≥l p ≥ 1 − f c &q < 1 − pM f
T urnkey
p ≥ 1q (1 − c+fM )&q ∈ [1 − pM f
, 1 − fM ) T urnkey
p < min{1 − f , q (1 − c+fM )}&q < 1 − fM
c 1
Buy − sel l /T urnkey
p≥1−  qf
c
&q ≥ 1 − fM T urnkey
p<1−  qf
c
&q ≥ 1 − fM Buy − sel l /T urnkey

Table 9
OEM’s optimal choice of outsourcing structure whenc ≥ M- (i)

Situation Optimal Strategy

f ∈ [M, c ) q < 1 − pM f

T urnkey
p ≥ 1q (1 − c+l M )&q ∈ [1 − pM
f
, 1 − fM ) T urnkey
p < q (1 − c+l M )&q ∈ [1 − pM
1
f
, 1 − fM ) Buy − sel l
p ≥ 1 − qlc &q ≥ 1 − fM T urnkey
p<1−  c
qf
Buy − sel l

profits under the turnkey and buy-sell structures. Theorem 5 pro- We depict these strategies in Fig. 3 to visualize the OEM opti-
vides the result. mal strategy under different conditions. Fig. 3-(a) corresponds to
Theorem 5-(1), and Fig. 3-(b) and Fig. 3-(c) correspond to the two
Theorem 5. The OEM’s optimal outsourcing structure is as follows: cases of Theorem 5-(2), respectively.
From Theorem 5, we find that the optimal outsourcing structure
(1) When c < M, the OEM’s optimal choice of outsourcing to adopt depends on the model parameters. So turnkey and buy-
structure is shown in Table 8: sell have their own applicable situations. This explains why some
(2) When c ≥ M, there are two situations: firms adopt turnkey while others adopt buy-sell.
c2 , the OEM’s optimal choice of outsourcing
I if l < c− M When the compensation is low, i.e., f < M, if the CM’s de-
structure is similar to that in (1) where c < M ex- fective probability is low and the defective rate of the low-type
cept, the OEM’s optimal choice of outsourcing structure supplier is large, buy-sell is not worse than turnkey; for other
is shown in Table 9.. case of f < M, turnkey is a better choice for the OEM. This is
c2 , the OEM’s optimal choice of outsourcing
II if l ≥ c−M inconsistent with our intuition. Intuitively, as long as the defec-
structure is similar to that in (1) where c < M, ex- tive rate of the low-type supplier is large, the OEM should adopt
l M
cept f ∈ [M, l− c ) and , the OEM’s optimal choice of buy-sell to ensure component quality. The reason is that the OEM
outsourcing structure is shown in Table 10. aims to maximize its profit and buying from the high-type sup-

8
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Fig. 3. The OEM’s optimal operations strategies

9
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

Fig. 3. Continued

Table 10 better if the defective rate of the low-type supplier is large; other-
OEM’s optimal choice of outsourcing structure whenc ≥ M- (ii)
wise, turnkey is better.
Situation Optimal Strategy When the compensation is very high, and higher than the
l M
f ∈ [M, l− q < 1 − pM OEM’s external failure cost (including the damage to the OEM’s
c ) f
T urnkey
p ≥ 1q (1 − c+l M )&q ∈ [1 − M
, 1 − fM ) T urnkey goodwill and future market share etc.), turnkey is the OEM’s best
pf
p < q (1 − c+l M )&q ∈ [1 −
1 M
pf
,1 − fM ) Buy − sel l choice.
p ≥ 1 − qlc &q ≥ 1 − fM T urnkey
p<1−  c
Buy − sel l
qf 5. Outsourcing with endogenous compensation
l M
f ∈ [ l− c , c ) p ≥ 1 − l c &q < 1 − pMf
T urnkey
p < 1 − l c &q < 1 − pMf
Buy − sel l
p ≥ 1q (1 − c+l M )&q ∈ [1 − M
, 1 − fM ) T urnkey In Section 4 we assumed that compensation is an exogenous
pf
p < q (1 −
1 c+M
)&q ∈ [1 − M
, 1 − fM ) Buy − sel l parameter (which is equal to the actual cost incurred by a defective
l pf
p ≥ 1 − qlc &q ≥ 1 − fM T urnkey product to the OEM). In some cases, the compensation is a decision
p < 1 − qlc &q ≥ 1 − fM Buy − sel l variable of the OEM and specified in the contract, which may not
equal the cost to the OEM. In this section we consider the case
where the compensation is a part of the contract rather than an
exogenous parameter. In this case, the contract offered by the OEM
plier may bring a higher profit when CM’s defective probability is is {w, f }.
low and the defective rate of the low-type supplier is large. This
result means that when the defective product is easy to fix, the 5.1. Turnkey structure
defective rate of the low-type supplier is large, and the CM’s de-
fective probability is high, turnkey could lead to a higher profit When the contract includes both the wholesale price and com-
to the OEM. In this situation, the optimal policy is to purchase pensation, the CM has the same dominant operations strategies to
from the low-type supplier and to adopt low-level process craft. those in Section 4 for a given price and compensation pair(w, f ).
For example, Huawei adopt turnkey to completely outsource some However, the optimal contract set by the OEM is different since the
low-level mobile phone products (from product design to final OEM needs to decide the compensation. When the compensation
products) to other manufacturers, such as Wingtech, Longcheer is an endogenous decision variable, we formulate the problem to
and Huaqin. These low-level products are basically used to satisfy decide the optimal contract under turnkey as the following opti-
consumers(e.g., the elderly) who do not need high-performance mization problem
smartphones.
When the compensation is high, i.e., f ≥ M, the situation be-
max πOEM T (w, f )
w≥0, f ≥0 (5.1)
comes more complex. The difference occurs when the CM’s defec- s.t. πCM T (w, f ) ≥ 0
tive probability is high, i.e., q < 1 − M/ f . In this case, buy-sell is

10
M. Zhang, J. Zhang, Y. Sun et al.
Let p1 :=(M − 1q (1 − q )c )/M, p2 :=M/(M + (1 − q )c ),
l1 :=c/q(1 − p), l2 :=M/(1 − q ), l3 :=c + M/(1 − pq ),
l4 :=M/ p(1 − q ), and l5 :=c/(1 − p). Theorem 6 gives the
equilibrium policy and the two players’ profits under turnkey.
Theorem 6. The OEM and CM’s equilibrium policies and profits under
turnkey are as follows:
(1) When p < p1 ,
(i) If l < l1 , then the optimal contract satisfies w − (1 −
pq ) f = cl + ML . The equilibrium policy is (L, L ), πCM T =
0, and πOEM T = r − cl − ML − (1 − pq )l;
(ii) If l1 ≤ l < l2 , then the optimal contract satisfies w − (1 −
q ) f = ch + ML . The equilibrium policy is (H, L ), πCM T =
0, and πOEM T = r − ch − ML − (1 − q )l;
(iii) If l ≥ l2 , then the optimal contract satisfies w = ch +
MH . The equilibrium policy is (H, H ), πCM T = 0, and
πOEM T = r − ch − MH .
(2) When p1 ≤ p < p2 ,
(i) If l < l3 , then the optimal contract satisfies w − (1 −
pq ) f = cl + ML . The equilibrium policy is (L, L ), πCM T =
0, and πOEM T = r − cl − ML − (1 − pq )l;
(ii) If l ≥ l3 , then the optimal contract satisfies w = ch +
MH . The equilibrium policy is (H, H ), πCM T = 0, and
πOEM T = r − ch − MH .
(3) When p ≥ p2 ,
(i) If l < l4 , then the optimal contract satisfies w − (1 −
pq ) f = cl + ML . The equilibrium policy is (L, L ), πCM T =
0, and πOEM T = r − cl − ML − (1 − pq )l;
(ii) If l4 ≤ l < l5 , then the optimal contract satisfies w − (1 −
p) f = cl + MH . The equilibrium policy is (L, H ), πCM T =
0, and πOEM T = r − cl − MH − (1 − p)l;
(iii) If l ≥ l5 , then the optimal contract satisfies w = ch +
MH . The equilibrium policy is (H, H ), πCM T = 0, and
πOEM T = r − ch − MH .
Obviously, when the compensation is a decision variable rather
than an exogenous parameter, the OEM has more freedom to de-
sign a contract to maximize its own profit. From Theorem 6, we
find that if the impact of a defective product on the OEM is small,
it is meaningless to incentivize the CM to purchase from the high-
type supplier or adopt the high-level process craft. Then the OEM
will design a contract to induce the CM to purchase from the low-
type supplier and adopt the low-level process craft. For example, a
defective screw may affect a phone’s quality, but it does not have
much impact and is easy to fix. For this kind of components, the
OEM needn’t incentivize the CM to purchase from high-type sup-
plier because the components from low-type supplier are not bad.
In this case, the contract offered by the OEM contains a low com-
pensation and ensures the CM to obtain a non-negative profit.
If the impact of a defective product on the OEM is quite large,
the OEM must ensure the final product’s quality. Thus, the OEM
will undoubtedly encourage the CM to purchase from the high-
type supplier and adopt the high-level process craft. This explains
why Mi’s sale volume experienced a cliff-like decline in 2016 due
to its quality problems. To reduce the cost, Mi offered its CMs a
low outsource wholesale price at that time. Then the CMs can only
provide Mi with low quality products, which resulted in a signifi-
cant drop in sale.
When the defective product leads to a medium loss to the OEM,
the CM will purchase from the high-type supplier but adopt the
low-level process craft if the defective rate of the low-type supply
is large. If the defective rate of the low-type supply is small, the
CM will purchase from the low-type supplier but adopt the high-
level process craft.
11
Omega 113 (2022) 102707
5.2. Buy-sell structure
In this subsection we consider the case where the OEM adopts
the buy-sell structure with an endogenous compensation. By simi-
lar arguments as in Section 5.1, we formulate the optimal contract
problem under buy-sell as the following optimization problem:
max πOEM B (w, f )
w≥0, f ≥0 (5.2)
s.t. πCM B (w, f ) ≥ 0
Theorem 7 gives the equilibrium policy and the two players’
profits under buy-sell.
Theorem 7. The OEM and CM’s equilibrium policies and profits under
buy-sell are as follows:
(i) If l < l2 , then any combination satisfies f < M/(1 − q ) and
w − (1 − q ) f = ξ ch + ML is the optimal contract. The equilib-
rium policy is (H, L ), πCM B = 0, and πOEM B = r − ch − ML −
(1 − q )l;
(ii) If l ≥ l2 , then any combination satisfies f ≥ M/(1 − q ) and
w = ξ ch + MH is the optimal contract. The equilibrium policy
is (H, H ), πCM B = 0, and πOEM B = r − ch − MH .
From Theorem 7, the OEM’s dominant operations strategy un-
der buy-sell is always to purchase from the high-type supplier. If
the impact of a defective product on the OEM is small, the CM
adopts the low-level process craft. Otherwise, high-level process
craft will be adopted.
From Theorems 6 and 7, we find that purchasing from the high-
type supplier does not necessarily bring a high profit. Sometimes
purchasing from the low-type supplier may bring a higher profit
for the OEM or even the whole supply chain. For instance, if a de-
fective product has a very small impact on the OEM, the OEM need
not purchase from the high-type supplier at very high cost. In this
case, pursuing from high-type supplier will only incur additional
costs and reduce the profit of the whole supply chain.
5.3. OEM’s optimal outsourcing decision
In this subsection we discuss the optimal decision on the out-
sourcing structure. Theorem 8 gives the results.
Theorem 8. When the compensation is an endogenous decision vari-
able of the OEM, its optimal operations strategy is as follows:
(1) When p < p1 , then πOEM T > πOEM B if l < l1 ; otherwise,
πOEM T = πOEM B .
(2) When p1 ≤ p < p2 , then πOEM T > πOEM B if l < l3 ; otherwise,
πOEM T = πOEM B .
(3) When p ≥ p2 , then πOEM T > πOEM B if l < l5 ; other-
wise,πOEM T = πOEM B .
Theorem 8 shows that if the impact of a defective product on
the OEM is small, then turnkey is better; if the impact is large,
then there is no difference between turnkey and buy-sell. In other
words, when the OEM can set the compensation in the contract, if
a defective product incurs a low loss to the OEM, then turnkey is
the optimal choice when the OEM outsources its production. This
is inconsistent with our intuition. Intuitively, buy-sell can bring a
higher profit to the OEM because it purchases components and
resells them to the CM. Also the OEM can purchase high-quality
components by itself if a defective product incurs a high loss to it.
The reason why buy-sell is not better than turnkey is that the OEM
can set a proper compensation to induce the CM to purchase com-
ponents from proper suppliers. As to why turnkey and buy-sell can
bring the same profit to the OEM when a defective product incurs
a high loss to the OEM, this is because the OEM could induce the
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

CM to purchase from the high-type supplier and adopt the high- Table 11
OEM’s optimal outsourcing choice considering market power if λ < 1
level process craft by providing a suitable contract under the two
structures. Situation Optimal Strategy

p < p1 l < l1 λ < λ1 πOEM T < πOEM B

6. Outsourcing with different market powers λ ≥ λ1 πOEM T ≥ πOEM B
l ≥ l1 - πOEM T < πOEM B
p1 ≤ p < p2 l < l2 λ < λ1 πOEM T < πOEM B
In the previous sections we assumed that the OEM and CM
λ ≥ λ1 πOEM T ≥ πOEM B
have the same market power and buy the component at the same l2 ≤ l < l3 λ < λ2 πOEM T < πOEM B
price from the supplier. Different firms have different market pow- λ ≥ λ2 πOEM T ≥ πOEM B
ers and acquire the same component at different costs. In this sec- l ≥ l3 - πOEM T < πOEM B
tion, considering the case where the OEM and CM have different p ≥ p2 l < l2 λ < λ1 πOEM T < πOEM B
λ ≥ λ1 πOEM T ≥ πOEM B
market powers (here “market power” means a firm’s ability to get l2 ≤ l < l4 λ < λ2 πOEM T < πOEM B
the component at a lower price) and acquire the component at dif- λ ≥ λ2 πOEM T ≥ πOEM B
ferent costs, we analyze the impacts of the players’ market powers l4 ≤ l < l5 λ < λ3 πOEM T < πOEM B
on the OEM’s choice of the outsourcing structure. λ ≥ λ3 πOEM T ≥ πOEM B
l ≥ l5 - πOEM T < πOEM B πOEM T < πOEM B
When the Turnkey strategy is adopted, then only the market
power of the CM has an impact on the optimal policy, so we set
the market power of the CM at 1. The analysis and results are the
same as those in Section 4.1. the OEM has a low market power, turnkey is better, but if the OEM
When the Buy-sell is adopted, there is a comparison between has a high market power, buy-sell could bring a higher profit to
CM and OEM. To simplify the analysis, we suppose that the CM’s the OEM than turnkey. However, our finding is different from this
market power is 1 and the OEM’s market power is λ. Then the CM intuition. The choice of the outsourcing structure depends on the
acquires the component at a price as in Section 4 but the OEM’s defective rate of the low-type supplier, the loss incurred by a de-
purchase price from the high-type supplier is λch and from the fective product to the OEM, and the OEM’s and CM’s market pow-
low-type supplier is λcl (λ > 0). The larger λ is, the smaller is the ers. If a defective product incurs a large loss to the OEM, buy-sell
OEM’s market power because its ability to acquire the component is the optimal outsourcing structure. This can explain why Apple
at a lower price is lower. Let its resell price be ci∗ =ξ λci (i = h, l ). adopts the buy-sell structure. The reason is that Apple has large
Obviously, λ > 1 means that the OEM’s market power is lower market power and can get components at low costs. Moreover, de-
than the CM’s, while λ < 1 means that the OEM’s market power fective products have large impacts on Apple. Also, Apple is confi-
is higher than the CM’s. To focus on examining the impact of mar- dent in the process drafts of its CMs, but is worried that the CMs
ket power, we keep the other model parameters unchanged. may buy the components from low-type suppliers. However, if a
Note that under turnkey, the CM is in charge of compo- defective product incurs a small loss to the OEM, only when the
nent procurement and its purchase price remains unchanged, OEM has a relative high market power will it choose buy-sell. This
Theorem 6 still holds when the OEM and CM have different mar- explains why so many mobile phone OEMs purchase chips, printed
ket powers since the CM gets the component with the same circuit boards, CPUs, memory chips, touch screens, and other im-
price as in Section 4. However, under buy-sell, the OEM is in portant components by themselves, but may outsource to CMs to
charge of component procurement, then its market power will af- purchase screws, plastics, and other unimportant components. This
fect the component’s purchase price. Thus Theorem 7 no longer also explains why Cisco adopts the turnkey structure. The reason is
holds. However, it is not difficult to find that the OEM’s mar- that Cisco uses the e-hub to strictly monitor its component suppli-
ket power has no effect on the equilibrium, but only affects its ers. So the components from low-type suppliers have low defective
own profit because its purchase price is multiplied by the same rates and have smaller impacts on it.
coefficient λ at the same time. The profits correspond to equi- Moreover, we note that the thresholds λ1 , λ2 , and λ3 increase
librium policies (H, L ) and (H, H ) are πOEM B = r − λch − ML − (1 − with cl and l, but decrease with ch and p. This implies that a
q )l and πOEM B = r − λch − MH , respectively. Obviously, the larger high purchase price from the low-type supplier or a large exter-
the OEM’s market power is (the smallerλis), the higher is its nal failure cost may incentivize the OEM with less market power
profit. Let λ1 :=(cl + q(1 − p)l )/ch , λ2 :=(cl + (1 − pq )l − M )/ch , to switch from turnkey to buy-sell. Conversely, when the purchase
and λ3 :=(cl + (1 − p)l )/ch . Theorem 9 gives the impacts of the price from the high-type supplier is high or the defective rate of
OEM’s market power on its profit and its choice of the outsourcing the low-type supplier is not very large, the OEM should adopt
structure. turnkey. The reason is that, if the loss incurred by a defective prod-
uct to the OEM is large, it should pay more attention to quality en-
Theorem 9. The OEM’s optimal choice of the outsourcing structure hancement and adopting the buy-sell structure undoubtedly guar-
considering its market power is as follows: antees the component’s quality. Also, if the defective rate of the
low-type supplier is not very large, outsourcing component pro-
(1) If λ > 1, then πOEM T > πOEM B .
curement to the CM, which will purchase from the low-type sup-
(2) If λ < 1, then the OEM’s optimal choice of outsourcing struc-
plier, will reduce the cost and bring a high profit to the OEM.
ture is shown in Table 11.
When the procurement cost difference between the two suppliers
Theorem 9 implies that if the OEM’s market power is smaller is small, buy-sell will bring a high profit to the OEM. But when
than the CM, it should choose the turnkey structure. Many not very the procurement cost difference is large, turnkey may have the
large firms such as Meizu, Smartisan, and 360 adopt the turnkey edge because it could reduce costs by purchasing from the low-
structure to outsource component purchasing to their CMs. This re- type supplier or adopting the low-level process craft.
sult is intuitive since turnkey ensures a lower procurement cost.
If the OEM’s market power is larger than the CM’s, i.e., λ < 1, 7. Conclusions
how to choose the outsourcing structure depends on the model pa-
rameters. Theorem 9 (2) states that it may not be profitable for the In this paper we study the optimal choice of the outsourcing
OEM to outsource component procurement to the CM with a high structure between turnkey and buy-sell considering quality man-
market power. This is inconsistent with our intuition. Intuitively, if agement when the OEM outsources its production. We first analyze

12
M. Zhang, J. Zhang, Y. Sun et al.
the OEM’s and CM’s equilibrium strategies, and the optimal con-
tracts and profits under turnkey and buy-sell, assuming the com-
pensation is an exogenous parameter. Then we characterize the op-
timal choice of the outsourcing structure by comparing the two
structures’ performance. We further consider the case where the
compensation is an endogenous variable. Finally, we study the im-
pacts of the OEM’s and CM’s market powers on the optimal deci-
sion on the outsourcing structure.
We have the following findings: For the case where the com-
pensation is an exogenous parameter, under turnkey, if the com-
pensation is very small, the CM’s optimal operations strategy is to
purchase from the low-type supplier and adopt the low-level pro-
cess craft. When the compensation is large, the CM may choose to
purchase from the high-type supplier or adopt the high-level pro-
cess craft. Under buy-sell, the OEM’s dominant operations strategy
is to purchase from the high-type supplier. If the compensation is
small, the CM will choose to adopt the low-level process craft; if
the compensation is high, the CM will choose to adopt the high-
level process craft when the non-defective rate of the low-level
process craft is low; otherwise, adopt the low-level process craft.
By comparing the OEM’s profits under turnkey and buy-sell,
we identify the conditions under which one outsourcing structure
dominants the other. Generally, when the compensation is larger
than the loss incurred by a defective product, the OEM should
choose turnkey. However, when the compensation is smaller than
the loss incurred by a defective product, the OEM’s optimal out-
sourcing structure depends on three factors: (a) the compensation,
(b) the defective rate of low-type supplier, (c) the CM’s defective
probability. Specifically, when the compensation is relatively small,
if the CM’s defective probability is low and the defective rate of
the low-type supplier is large, buy-sell is not worse than turnkey;
otherwise, turnkey is a better choice for the OEM. When the com-
pensation is relatively large and the CM’s defective probability is
low, its optimal operations strategy is the same as above; but if the
CM’s defective probability is high, buy-sell is a good choice if the
defective rate of the low-type supplier is large; otherwise, turnkey
is better.
For the case where the compensation is an endogenous deci-
sion variable, the OEM has more freedom to make decisions. (i)
Under turnkey, if the loss incurred by a defective product is low,
the OEM’s optimal strategy is to incentivize the CM to purchase
from the low-type supplier and adopt the low-level process craft.
But if the loss incurred by a defective product is high, the OEM
should incentivize the CM to purchase from the high-type supplier
and adopt the high-level process craft. If the loss incurred by a de-
fective product is medium, the OEM should incentivize the CM to
purchase from the high-type supplier and adopt the low-level pro-
cess craft when the component’s non-defective rate from the low-
type supplier is low. The OEM should motivate the CM to purchase
from the low-type supplier and adopt the high-level process craft
when the component’s non-defective rate from the low-type sup-
plier is high. (ii) Under buy-sell, if the loss incurred by a defective
product is low, it is optimal for the CM to adopt the low-level pro-
cess craft; but if the loss incurred by a defective product is high,
then the CM should adopt the high-level process craft. The OEM
should choose the turnkey structure.
For the case that the two players have different market power,
if the OEM has a low market power, he should choose turnkey
structure. If the OEM has a high market power, only when the
loss incurred by a defective product is low and the OEM’s market
power is not very high, the OEM should choose turnkey structure;
otherwise, buy-sell is better.
In this paper we get some non-intuitive conclusions:
(1) OEM may still adopt Turnkey even if the low-type suppliers
have a high defective rate. Intuitively, OEM should use buy-
13
Omega 113 (2022) 102707
sell to ensure quality as long as the low-type supplier has a
large defective rate. The reason is that purchasing from high-
type suppliers may lead to higher profits in some situations.
(2) Turnkey is optimal when the impact of a defective product
on the OEM is small. The intuition is buy-sell can be more
profitable for the OEM because it resells components to CM
and ensures quality. This is because the OEM can set the
proper compensation to induce the CM to purchase compo-
nents from proper supplier. This can ensure product quality
and reduce costs.
(3) For OEM, it may not be profitable to use Turnkey for CM
with higher market power. If a defective product brings sig-
nificant losses to the OEM, buy-sell is the optimal outsourc-
ing structure. This counter to the intuition that it is better
to adopt turnkey if the OEM has low market power.
Based on this study, we suggest some topics for future research
as follows:
The first one is to consider other quality management ap-
proaches. This paper is based on the external failure-based ap-
proach. However, the inspection-based approach is also popular in
quality management. So studying the outsourcing structure choice
considering the inspection-based approach is an interesting topic.
To simply the analysis, we assume that the root cause of the
external failure can be easily analyzed, and that the root cause
analysis is accurate and its cost is zero. In reality, the root cause
analysis is difficult and costly. Then it is interesting to examine the
situation where the root cause analysis is inaccurate and it has a
positive cost.
Other than turnkey and buy-sell, there are other outsourcing
structures in practice, such as turnkey with audits, supplier re-
bates, consignment, and so on [53]. Investigating such outsourcing
structures considering quality management is also an interesting
topic for future research.
In this paper we assume that the information on the purchase
cost of each party is transparent to simplify the analysis. In reality,
the cost information is asymmetric. Then calibrating the value of
information sharing or designing feasible mechanisms to promote
information sharing is an interesting topic for future research.
CRediT authorship contribution statement
Manman Zhang: Conceptualization, Methodology. Juliang
Zhang: Supervision. Yue Sun: Writing – original draft. T.C.E.
Cheng: Writing – review & editing.
Acknowledgments
We thank the Editor and anonymous referees for their many
helpful comments on an earlier version of our paper. This work
was supported in part by the National Natural Science Founda-
tion of China under grant numbers 72171016 and 71661167009, the
NSFC/RGC joint support scheme under grant number 3-RAA7, and
Beijing Logistics Informatics Research Base. Cheng was also sup-
ported in part by The Hong Kong Polytechnic University under the
Fung Yiu King-Wing Hang Bank Endowed Professorship in Business
Administration.
Appendix
A.1. Proof of Lemma 1
First we discuss the conditions under which policy(H, H ) is op-
timal for the CM. From (3.1), (3.2), and (3.3), we have

πCM T (H, H ) − πCM T (H, L ) > 0 ⇒ −M + (1 − q ) f > 0
πCM T (H, H ) − πCM T (L, H ) > 0 ⇒ −c + (1 − p) f > 0 .
πCM T (H, H ) − πCM T (L, L ) > 0 ⇒ −c − M + (1 − pq ) f > 0
M. Zhang, J. Zhang, Y. Sun et al. Omega 113 (2022) 102707

(A1)
Eq. (A1) is equivalent to the following conditions: f ≥ c + M,
p < min{1 − f c , 1q (1 − c+fM )}, andq < 1 − fM .
By similar arguments, we obtain the conditions under which
policies (H, L ), (L, H ), and (L, L ) are optimal for the CM, respec-
tively.
A.2. Proof of Proposition 1
To maximize its profit, the OEM will set the wholesale price to
take all of the surplus, so the CM’s profit can only be 0 and the
constraint in (3.5) is bounded. From this, we find the solution by
simple calculation.
(A2)
Case (b): (H, L )is the dominant operations strategy if and only
if

r − c h − M L − ( 1 − q ) l > r − c h − M H ⇒ M < ( 1 − q ) l
r − c h − M L − ( 1 − q ) l > r − c l − M H − ( 1 − p ) l ⇒ M − c > ( p − q ) l .
r − ch − ML − (1 − q )l > r − cl − ML − (1 − pq )l ⇒ c < q(1 − p)l
(A3)
Case (c): (L, H )is the dominant operations strategy if and only
if

r − c l − M H − ( 1 − p ) l > r − c h − M H ⇒ c > ( 1 − p ) l
r − c l − M H − ( 1 − p ) l > r − c h − M L − ( 1 − q ) l ⇒ M − c < ( p − q ) l .
r − cl − MH − (1 − p)l > r − cl − ML − (1 − pq )l ⇒ M < p(1 − q )l

A.3. Proof of Lemma 2 (A4)

First we consider the OEM’s optimal purchase decision. By com- Case (d): (L, L )is the dominant operations strategy if and only if
paring the OEM’s profits by purchasing from the high-type supplier
and purchasing from the low-type supplier, we find that no matter 
r − cl − ML − (1 − pq )l > r − ch − MH ⇒ c + M > (1 − pq )l
what the CM’s decision is, the OEM’s decisions is the same. That is, r − cl − ML − (1 − pq )l > r − ch − ML − (1 − q )l ⇒ c > q(1 − p)l .
the OEM will obtain more profit by purchasing from the high-type r − cl − ML − (1 − pq )l > r − cl − MH − (1 − p)l ⇒ M > p(1 − q )l
supplier. So α = 1.
(A5)
Then we consider the CM’s decision. Since the difference
betweenw − ξ ch − MH and w − ξ ch − ML − (1 − q ) f is −M + (1 −
q ) f , w − ξ ch − MH < w − ξ ch − ML − (1 − q ) f when f < M/(1−q ). Note that
Hence, the pure strategy (1,0) brings more profit to the CM; when ⎧ M−c
⎪ < c
= l5 ⇒ p > M− (1−q )c
f > M/(1−q ),w − ξ ch − MH > w − ξ ch − ML − (1 − q ) f and the pure ⎪
⎪ p−q 1−p M
⎪
⎪ M−c c
= l1 ⇒ p > M+ 1(M
strategy (1,1) is optimal. When f = M/(1−q ), the profit is the same ⎨ p−q < q(1−p) q 1−q )c
M−c M M−(1−q )c
for the CM. < = l 2 ⇒ p > M . (A6)
⎪
⎪
p−q
M−c
1−q
M
When f ≤ l, strategy (1,1) brings more profit to the OEM. Other- ⎪
⎪ < p(1−q )
= l4 ⇒ p > M+ 1(M
wise, strategy (1,0) brings more profit to the OEM. ⎪
⎩
p−q
q 1−q )c
(1+q )M−(1−q )c
M−c c+M
p−q
< 1−pq
= l 3 ⇒ p > (1+q )M+(1−q )c
A.4. Proof of Proposition 2 Then we can derive the dominant operations strategies in dif-
ferent cases from (A2)-(A6).
By similar arguments as in the proof of Proposition 1, we have
πCM T (w ) = 0. From Lemma 2 and Corollary 1, we find the solution A.7. Proof of Theorem 7
by simple calculation.
From Lemma 2 and Proposition 2, we find that under buy-sell,
A.5. Proof of Theorem 5 there are only two options: (H, L ) and (H, H ).
Since the difference between πOEM B (H, L ) = r − ch − ML − (1 −
We start with the case where c < M and f < c. From q )l and πOEM
B (H, H ) = r − ch − MH is M − (1 − q )l, the dominant
Propositions 1 and 2, the profits of the OEM under turnkey and operations strategy is (H, L ) if l < 1−q
M
= l2 ; otherwise, the domi-
buy-sell are as follows: nant operations strategy is (H, H ).
Note that f is a decision variable and there are three cases:
Situation πOEM T πOEM B
c < M& f < c r − cl − ML − (1 − pq )l r − ch − ML − ( 1 − q )l
(i) f < M. From Proposition 2, the dominant operations strat-
egy is (H, L ).
Since the difference betweenπOEM T and πOEM B is c + q( p − 1 )l, (ii) M ≤ f < 1−q M
. In this case, q ≥ 1 − fM and the dominant
πOEM T > πOEM B when p > 1 − qlc . Then the OEM chooses turnkey. operations strategy is (H, L ).
When p < 1 − qlc , πOEM T < πOEM B and buy-sell is the OEM’s op- (iii) ) f ≥ 1−q
M
. In this case, q < 1 − fM and the dominant opera-
timal choice. When p = 1 − qlc , the OEM obtains the same profit tions strategy is (H, H ).
under the two structures. Fig. 1(a) (i) depicts the optimal policy Then we prove Theorem 7.
for this case.
For the other cases, we can derive the optimal policies by sim- A.8. Proof of Theorem 8
ilar arguments.
From Theorems 6 and 7, we can find the profits of the OEM
A.6. Proof of Theorem 6 under turnkey and buy-sell when the compensation is a decision
variable. From this, we discuss the optimal operations strategy.
We have the following four cases: First we consider the case where p < p1 . The OEM’s profits are as
Case (a): (H, H )is the dominant operations strategy if and only follows:
if
Situation πOEM T πOEM B

r − ch − MH > r − cl − ML − (1 − pq )l ⇒ c + M < (1 − pq )l p < l < l1 r − cl − ML − (1 − pq )l r − ch − ML − ( 1 − q )l
r − c h − M H > r − c h − M L − ( 1 − q ) l ⇒ M < ( 1 − q ) l . p1 l1 ≤ l < l2 r − ch − ML − ( 1 − q )l r − ch − ML − ( 1 − q )l
r − c h − M H > r − c l − M H − ( 1 − p ) l ⇒ c < ( 1 − p ) l l ≥ l2 r − ch − MH r − ch − MH

14
M. Zhang, J. Zhang, Y. Sun et al.
When l < l1 , πOEM
T > πOEM
B since the difference between πOEM T
and πOEM isc − q(1 − p)l > 0 (l < l1 = q(1−p
B c
) ). When l1 ≤ l < l2
and l ≥ l2 , the OEM’s profits are the same under turnkey and buy-
sell. Then we prove Theorem 8 (1).
By similar arguments, we reach the conclusions for the other
cases.
A.9. Proof of Theorem 9
The OEM’s and the CM’s expected profits with different market
powers are similar to those in Theorem 8. The difference is that
we replace c by λc under buy-sell. We consider the case where
p < p1 and λ < 1. The OEM’s profits in this case are as follows:
Situation πOEM T πOEM B
p < l < l1 r − cl − ML − (1 − pq )l r − λch − ML − (1 − q )l
p1 l1 ≤ l < l2 r − ch − ML − ( 1 − q )l r − λch − ML − (1 − q )l
l ≥ l2 r − ch − MH r − λch − MH
(i) l < l1 , the difference between πOEM T and πOEM B is λch − cl −
cl +q (1−p)l
q(1 − p)l. Then πOEM T < πOEM B when λ < ch ; other-
wise, πOEM ≥ πOEM
T B.
(ii) l1 ≤ l < l2 , the difference between πOEM T and πOEM B is
ch (λ − 1 ). Then πOEM T < πOEM B .
(iii) l ≥ l2 , the difference between πOEM T and πOEM B is ch (λ − 1 ).
Then πOEM T < πOEM B .
For the other cases, we can derive the results by similar argu-
ments.
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